Credit Spread (Options) Explained - Derivatives

In finance, a credit spread (or net credit spread) is an option strategy that involves buying one option and selling another option in the same class.

It is designed to make profits when the spread between the two options is narrowed, and investors want that spread to narrow before they run out of profit. The investor must pay to receive the risk premium, but gets the net credits to enter the position. 

In this context, a narrowing means that the options sold by the trader are in the money at the end of the run, the net premium he receives, in which case the trade is profitable, and the maximum that would be realised before the option premium expires is worthless. A bullish option strategy is used when option traders expect the underlying share price to go up. Moderately bullish option traders usually set a price target for a bull run and use the bull premium to lower costs. Before deciding on the optimal trading strategy, one must estimate how high share prices can rise and in what timeframe the rally will take place. 

Although the maximum return of this strategy is limited, it costs less when used at a specific nominal level of engagement, such as at the end of a bull run. 

Bull spreads and bull spreads are common examples of moderately bullish strategies, and bear option strategies are used when option traders expect the underlying share price to go down. Options traders with moderate bear stocks typically set a price target for an expected decline and use bear spreads for lower costs. Before choosing the optimal trading strategy, one must estimate how deeply share prices can fall and in what timeframe the decline will occur. 

If the strategy's maximum return is limited, it will cost less in the long run, but not as much as a bear option strategy. 

To calculate the break - even point of a call spread - the net premium is added to the lower strike price and subtracted from the higher strike price until the put spread is balanced. A common example of the moderate bear strategy is a put-to-call spread with a high call price of $1.00 per share. 

Most brokers will allow you to define your definition of risk and your definition of return. The maximum profit and loss potential is the same for call and put spreads, but not for call spreads. 

The maximum loss is the difference between the exercise price and the net credit (note the premium difference "net credit"). If the option expires without money, you will realize the net balance as a result of the call spread, but you will not realize the net balance. 

The sub-maximum loss is the difference between the exercise price and the expected short options payout. If the option expires without money, you will be aware of the net balance due to the call spread, but you will not realize any of it. 

A credit spread, for example, is a conservative strategy designed to generate modest revenue for a trader by strictly limiting losses. If the price of the Underlying is below the expiry date of an exercise option, you will not see any of it and the trader will not make money. The risk premium on credit is negative, because if the prices of the underlying do not change, traders tend to make money when volatility falls. By contrast, credit spreads are positive, because if the prices of the underlying do not fall below the strike, traders tend to make money all the time. 

If a trader is a bear and he or she expects prices to fall, a "bear-like" call spread can be used. This is like buying options on the same security or index in the same month at a different exercise price. It is like calling to buy or sell a call, but to take a position that you cannot take. 

Consider the following example of a credit spread on the S & P 500 Index (NYSE: SPY) for March 2016. 

Trader Joe's expects XYZ to fall to its current price of $35 a share, and the options expire. If the stock rises to $37 by the end of the term, the position can be reversed by buying the 37 call trade and selling the 36 call back trade that was purchased when the difference is 1% of the strike price. In this case, the dealer retains the same amount of money as the call-back option, $1,000, resulting in a profit of about $330. The stock will remain at $36 when it falls to the $39.00 mark - the price for the next three months, but it is likely to fall or even fall further, falling as low as $34.50. 

For each of the ten calls, it costs $1,000, and if you deduct $350, you lose a maximum of $650. 

If the final price was $36 or $37, your loss would be smaller but less - even at that share price, less than half the money you received in advance. 

Traders use charts, software, and technical analysis to find overbought stocks that are rising in price but likely to be sold or stagnant, as candidates for bearish call spreads. If the trader is bullish, he or she uses a credit spread with bullish puts and a bullish call spread on bullish stocks of the stock. 

Consider this example: Trader Joe's expects the stock to soar to its current price of $20 a share. If the share price falls below $15, the put loses its value and the position is bought, while the 19 puts are bought at $4 and 18 puts are sold for $3, with the difference of $1 costing $1,000. The stock is rising steeply and if it falls or stays, you have to keep the $350 commission on the 20%, but if the share price goes up sharply, it has to be sold at a lower price. 

Traders often scan the price table and use technical analysis to look for candidates for bullish put spreads, such as stocks that have been oversold, fall sharply or may be on the verge of recovery, as a candidate is for a bullish put spread. In this case, the loss of profit is strictly limited: the maximum loss is $650, with less than $350 in loans. Even the share price is above the credit's strike price at $18.65. The final share prices of 18 and 19 would give you a small loss and profit, but not much more than that.