Credit spreads allow traders to profit in a neutral market or slight directional bias. This strategy requires a margin account and a trading account with more money. It might limit the number of trades you can make if you have an account less than $5,000. This is an options selling strategy that puts the trading odds most in your favor. You’re selling the spread to an options buyer and collecting a premium. If the price closes above or below your strike, depending on strategy, you get to collect the full premium by the expiration date.
Credits spreads are an options strategy in which you sell an option at one price and buy another with the same expiration. This creates a net credit called a premium. If the price closes above or below your short strike at expiration, depending on strategy, then you keep the premium. Credit spreads are options strategies traders use to make money in a sideways market. A trader can use many different options and techniques, but this post will focus specifically on credit spreads.
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Table of Contents
What Are Credit Spreads?
The stock market is a tug-of-war between buyers and sellers. Each day, one side tries to take control. Sometimes, stocks are flying, and other days are plummeting. What about those days when the price trades sideways? Is there any way to profit in that kind of market?
The answer is yes. That’s why they were designed. Anyone paying attention to the market recently has experienced the pain of a sideways trading market—especially swing traders. Add credit spreads to swing trading techniques. This increases your chances for profit.
One stock options contract is 100 shares of a stock. Options are cheaper because you’re paying less to control 100 shares than if you were to buy those 100 shares outright.
A credit spread comprises at least two contracts, which is 200 shares. You can do more. A credit spread gets its name from the way it’s set up. You receive cash for executing them. The credit to your account is why this strategy was given the name of credit. The opposite is called a debit spread.
Basics
Credit spreads options strategies allow traders to exploit time decay (theta) without choosing a direction. Buying calls and puts makes you have to choose a direction.
Credit spread strategies were invented to reduce margin requirements for naked options. The investor writes naked options to sell options without having a position. Writing a credit spread gives you, as a trader, less margin requirement.
Spreads have something known as “legs”. This means options traders take a two-sided position. In this case, there are the short leg and the long leg.
The short legs of a credit spread make up the premium to offset the price of the long legs. The long legs of credit spreads are the cheaper options and act as collateral. Hence, money is credited to the trading account.
Pros and Cons of Credit Spreads
Just like with anything in the stock market, there are advantages and disadvantages to spreads. One of the greatest advantages of a credit spread options strategy is that you don’t have to be correct in your assumption of direction. You can be 100% wrong and still profit.
With stocks, you either go long or short. Options trading allows more flexibility but also greater risk. If you can stomach more risk, options trading is a great way to profit in any market.
Another advantage to credit spreads options strategies is receiving the cash upfront. Hence the name of the strategy. The limited risk is also nice.
A disadvantage to credit spreads is the need for margin. The profit potential is also limited. That can be okay if you’re not looking to hit it out of the park every time. A $500 move is a great way to keep plugging along with profits.
A stagnant stock is profitable for spreads. They can be neutral without needing a call or put to surge in one direction. While volatility is needed to profit, this method doesn’t need that aspect.
Traders may like the unlimited profit potential of a call or put option. The profit ceiling may not seem ideal to some but think of the ability to profit in a market that can’t choose a direction.
Call Credit Spreads
Call credit spreads, or bear call spreads, are among the many options trading strategies available to traders. They’re a great way to protect your account while making money. You’ll need to explore different strategies to determine what type of trader you are.
Credit spreads allow traders to profit in any market, up, down, or sideways. The profit potential may not be unlimited, but the risk is limited. You can profit even from being wrong in your speculation. Make sure to practice them in a simulated account before using real money. Practicing allows you, as a trader, to fine-tune your strategy.
Trading Call Credit Spreads
- Sell one call (this is the short call)
- Buy one call (this is the long call) with a price above the short call
Example
Let’s take DOW and assume it is trading at $90 a share. To employ a call credit spread, I would sell the 95-strike call for $2.00 and buy the 100-call strike for $1.00. The net credit I receive for this trade is $1.00 or $100. Cool huh?
The best-case scenario for call credit spreads is for the underlying security to decline or stay the same. So, your trade is a winner if the DOW is below $53 at expiration (short strike price).
KEY: For this trade to become unprofitable, DOW has to rally $3.00 from $50 to $53. We can always close the trade anytime we want. Sometimes, I close the short side of the trade when I am wrong, hold the long side through the momentum, recoup some losses, and even make some profits.
Profit and Loss
- Maximum Profit = Premium You Receive (premium = money)
- Maximum Loss = Width of Strikes – Premium Received
Break Even
Calculating the break-even point for the call credit spread takes little work. You add the net premium received to the strike price of the short call option.
In the case of DOW, the stock can trade up to $53.50 per share at expiration before the call credit spread loses money.
Remember to plan your trade and trade your plan. With options, it’s important to know your break-even price.
That goes a long way in helping you decide if the trade has the potential to be profitable. Remember that with options, more moving parts affect profit and loss.
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Why Trade Call Credit Spreads?
Your primary goal with a call credit spread is to pocket the premium you get from placing the trade. Furthermore, considering you cap your loss, they’re a fantastic way to take advantage of time decay.
This is where the call credit spread option strategy shines.
Depending on how far out of the money the credit spread is, you will make money if the underlying rises slightly in price. You make money if the underlying price doesn’t move if it completely crashes or moves down slightly. It’s a win-win all around.
In a nutshell, call credit spreads are a hedged version of the short-call option strategy. You are hedged by purchasing a long call to minimize risk or loss. This is called “legging in” to a call credit spread in the trading world.
What’s nice about call credit spreads is it’s a risk-defined trade. Therefore, the buying power required to employ a call credit spread equals the maximum loss minus the premium received for placing the trade.
In the case of DOW, the margin requirement is $170, which is also the maximum loss. However, the limited risk of this strategy also comes with limited rewards.
That’s not a bad thing, though. Many times, traders only want to trade the home runs. But protecting yourself with limited risk helps protect your brokerage account.
That’s more important than trying to make $10,000 a trade. I’m not saying you can’t do that, but you protect yourself by pairing that with limited risk strategies.
What About Time (Theta) Decay?
Regarding call credit spreads, time decay is on your side. Time premium comes out of the short option leg of the trade, regardless of what direction the underlying security goes.
On the same token, the long call will also lose value due to time decay. However, since the long call is always further away from the short call, theta decay will always be higher for the short call.
In other words, this offsets the theta from the long call. Remember those moving options parts? Theta is one of them, and a highly effective one at that. It either hurts or helps, depending on how you use it in your trade.
Closing Out Call Credit Spreads
As a general rule, close out the call credit spread before expiration when the premium approaches zero. What’s more, another great strategy to eliminate risk on a profitable spread is only to close out the short call portion.
Additionally, you can leave the long call alone, typically because it will be worthless. There’s no point really in selling it for $0.01. The fact is, the remaining long call becomes a free ride.
If you’ve been in the options trading world long enough, closing out the call credit spread by first closing the short call is known as “legging out” of the spread.
What About Expiration?
Like all vertical options spread strategies, there’s a chance the underlying price will land somewhere between the spread’s short- and long-strike prices upon expiration.
So, you risk potential assignment if the short call expires in the money and the long call expires out of the money. An assignment risk exists for any stock option seller when the short option is in-the-money. However, it is infrequent.
Typically, your options broker will notify you if you have any expiring options that might cause a negative margin impact on your account. But it would be best not to depend on your broker to monitor this.
You must watch your call credit spreads near the money on the expiration day to see if you’re potentially at risk for assignment.
Takeaways
- It’s a bearish to neutral-strategy
- You make money when the stock price decreases, stays the same, or slightly increases.
- Limited risk, therefore, limited reward
- It’s merely a short call with a long call.
- The long call is used as a hedge to prevent upside loss – which can be unlimited.
- Overall time (theta) decay is beneficial but is slightly offset by the long call option.
- Ally Invest is the best and cheapest broker to trade call credit spreads
- The strategy is similar to trading a short call, except there is an added hedge of a long call.
Put Credit Spreads
Put credit spreads options are a bullish, neutral, and slightly bearish options trading strategy. You simultaneously sell and buy a put option to run a put credit spread. You pocket the premium yet limit the potential losses associated with naked short options if the price stays above the short strike by expiration.
Trading Put Credit Spreads
- Sell one put (this is the short put)
- Buy one put (this is further out-of-the-money (OTM) from the short put you sold)
- This one protects you from losses and lowers the buying power you need to enter this trade (margin account required)
Example
Let’s take DOW, for example. Currently, it is trading at $60 a share. To employ a put credit spread, I would sell the 50 put for $3.10 and buy the 55 put for $1.50.
The net credit I receive for this trade is $2.00 or $200, hence why this strategy is called a “credit” spread.
The best-case scenario for a put credit spread is for the underlying security, DOW stock, in this case, to rally and move up. However, if DOW sells off, the put credit spread will increase in value, and it’s a loss.
Like other credit spreads, as expiration nears, it will benefit from time or theta decay unless they are completely ITM.
Break Even
Calculating the break-even point for the put credit spread is quite simple. You subtract the premium received from the strike price of the short call option. In the case of DOW, the break-even point is $47.30.
Stock Signals & Alerts
Why Trade Put Credit Spreads?
A bullish outlook is one of the most common reasons to run a put credit spread, but not the only one. This may come as a surprise to you, but put credit spreads can be profitable in three different scenarios.
You make money if the underlying asset price moves up. And you make money if the underlying asset price stays the same. Finally, you make money if the underlying asset price moves down slightly.
They are extremely popular trades because of their ability to make money in three different scenarios. They protect your brokerage account also.
What’s more, your risk is capped. With a short put, for example, your risk of loss is monstrous. Even though it has a similar profit structure, you stand to lose a lot of money if the trade goes against you.
With a spread, you’re protected. And if you’re like me and like to be able to sleep at night, I strongly advise you to protect yourself.
What About Time (Theta) Decay?
Like call credit spreads, time decay is on your side with put credit spreads. Regardless of how the underlying goes, the time premium will come out of the short option leg of the trade.
Similarly, the long call will also lose value due to time decay. However, the premium from the short option leg will always be greater. Which means it offsets the long option theta.
Spreads are a few strategies where time decay doesn’t ultimately hurt you. Again, this is one of those moving parts that affect options.
Closing Out Put Credit Spreads
Like all vertical options spread strategies, you risk the underlying price falling between the short- and long-strike prices of the spread upon expiration.
Moreover, the risk depends on the settlement procedures associated with your trading asset.
Let’s take an asset settled in cash, like the SPX and EX. I just wanted to let you know there is nothing to worry about.
But that’s not the case if you sell spreads on individual stocks. You run the risk of the short strike expiring in the money and the long strike expiring worthless.
If this happens, you will be long 100 shares of stock for every short put. Typically, I wouldn’t see this as an issue if you have enough buying power in your account. If not, well, that’s another story. Enter the dreaded margin call.
Typically, your options broker will notify you if you have any expiring options that might cause a negative margin impact on your account. But it would be best not to depend on your broker to monitor this.
You must monitor your credit spreads near expiration to see if you’re potentially at risk for assignment.
Takeaways
- You make the most money when the underlying asset rallies or stays the same
- Your position is bullish, neutral slightly bearish
- Trade them when you think a stock will rise in price, but you don’t want to buy only call options
- Limited risk, therefore, limited reward
- It’s simply a short call with a long call used as a hedge to prevent unlimited upside loss.
- They are simply a protected version of short puts.
- Time decay is on your side
- You will not lose money if volatility explodes
- Ally Invest is one of the cheapest online brokers to trade credit spreads.
- The opposite strategy is a put-debit spread
I like credit spreads as risk and profit are defined. And the put credit spread is less sensitive to changes in volatility.
The put credit spreads strategy is a great way to profit from selling put option premium without worrying about losing your hard-earned dollars due to volatility.
Frequently Asked Questions
Ideally, you'd like to close out your credit spreads before expiration and take a profit. 50% POP (probability of profit) is a good place to take profit. If you hold until expiration, you are at risk of assignment. However, your broker will take care of the process. It's best to take profit and close a credit spread before expiration.
When implementing a credit spread trade, the premium you pay is less than the premium of the sold option, thus producing a net credit; if the stock price stays above or below the short anchor strike before expiration, depending on your strategy, you get to keep the premium. That's how credit spreads make money.
Maximum Profit = Premium Received
Maximum Loss = Width of Strikes - Premium Received
The maximum profit for the example trade above is $0.30 ($30). The max loss is $1.70 ($170). A put credit spread would be a complete losing trade if, at expiration, both legs of the spread expired in-the-money.
If DOW stays above $48 at expiration (the short put's strike price), then the spread will be a full winner.
Credit spreads come with a predetermined risk and reward. There's a maximum amount you can lose. In addition, there is a maximum amount of profit to be made. In other words, you do hit a profit ceiling, which may come into effect if you are trading options for a living. Time decay plays a large part in the profit of the credit spread. For this reason, the sideways market is a good thing. Money is made off the time value instead of the direction the stock moves.
