Table of Contents
- What Are Credit Spreads and How Do They Work?
- Call Credit Spreads
- How to Trade Call Credit Spreads
- Real Life Example of a Call Credit Spread
- Profit and Loss
- The Bottom Line
- Break Even for Call Credit Spreads
- Why Trade Call Credit Spreads?
- Margin Requirements
- What About Time (Theta) Decay?
- When Should You Close Call Credit Spreads?
- Other Things to Keep in Mind About Expiration
- Key Points of Call Credit Spreads
- Put Credit Spreads
- Frequently Asked Questions
What Are Credit Spreads and How Do They Work?
Credits spreads are an options strategy in which you sell an option at one price and buy another option with the same expiration. This creates a net credit called a premium. If price closes above or below your short strike at expiration, depending on strategy, then you keep the premium. Credit spreads are options strategies used by traders to make money in a sideways market. There are many different options techniques a trader can use, but for the purpose of this post we will be focusing on credit spreads specifically.
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 plummeting. What about those days where price just 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. In fact, 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 is made up of at least 2 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 in fact, why this strategy was given the name of credit. The opposite is called a debit spread.
Credit spreads options strategies allow traders to exploit time decay (theta) without having to chose a direction. Buying calls and puts makes you have to chose a direction.
Purpose of Credit Spreads
Credit spread strategies were invented to reduce margin requirements for naked options. Naked options are written by the investor 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, the crediting of money to the trading account.
Advantages and Disadvantages
Just like with anything in the stock market there are advantages and disadvantages to spreads. One if the greatest advantages to a credit spread options strategy is that you don’t have to be correct on 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 up front. 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 ok 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.
Call Credit Spreads
Call credit spreads, also known as bear call spreads are one of the many options trading strategies available to traders. They’re a great way to protect your account while making money. Exploring different strategies is a must if you are to figure out what type of trader you are.
How to Trade Call Credit Spreads
- Sell 1 call (this is the short call)
- Buy 1 call (this is the long call) with a price above the short call
Real Life Example of a Call Credit Spread
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. In total, 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, if the DOW is anywhere below $53 at expiration (short strike price), your trade is a winner.
KEY: For this trade to become unprofitable, DOW has to rally $3.00 from the current price of $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, and hold the long side through the momentum, and 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
The Bottom Line
Credit spreads allow traders to profit in any market whether up, down or sideways. The profit potential may not be unlimited but the risk is limited. In fact, you can profit even 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. If you need more help, take our options trading course.
Break Even for Call Credit Spreads
Calculating the break-even point for the call credit spread doesn’t take much 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.
Don’t forget 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. Don’t forget that with options, there are more moving parts that affect profit and loss.
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, they’re a fantastic way to take advantage of time decay, considering you cap your loss.
In fact, 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 if it 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 because you purchase a long call to minimize your risk or loss. In the trading world, this is called “legging in” to a call credit spread.
Margin Requirements
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 is equal to 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 reward.
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.
We’d argue that’s more important than trying to make $10,000 a trade. Not saying you can’t do that; but when you pair that with limited risk strategies, you’re protecting yourself.
What About Time (Theta) Decay?
In the case of 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.
When Should You Close Call Credit Spreads?
As a general rule of thumb, close out the call credit spread when the premium approaches zero before expiration. What’s more, another great strategy to eliminate risk on a profitable spread is only to close out the short call portion.
Additionally, this means 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 of the matter 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.
Other Things to Keep in Mind About Expiration
Like all vertical options spread strategies, there’s a chance the price of the underlying will land somewhere between the short and long strike prices of the spread come expiration.
So you run the risk of 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 the reality is, you shouldn’t depend on your broker to monitor this for you.
You must watch your call credit spreads that are near-the-money the day of expiration to see if you’re potentially at risk for assignment.
Key Points of Call Credit Spreads
- It’s a bearish to neutral strategy
- You make money when the stock price goes down, stays the same, or slightly moves up
- 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. In order to run a put credit spread, you simultaneously sell and buy a put option. You pocket the premium yet limit the potential huge losses associated with naked short options if price stays above short strike by expiration.
How to Trade Put Credit Spreads
- Sell 1 put (this is the short put )
- Buy 1 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)
Real Life Example of a Put Credit Spread
Let’s take DOW for example. Currently, it is trading at $60 a share. In order 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.
Your Break Even for Put Credit Spreads
It’s quite simple to calculate the break-even point for the put credit spread. You simply 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.
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.
Because of their ability to make money in three different scenarios, they are extremely popular trades to make. 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 what way the underlying goes, 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 coming out of the short option leg will always be greater. Which means, it offsets the long option theta.
Spreads are one of the few strategies were time decay doesn’t ultimately hurt you. Again this is apart of those moving parts that affect options.
When Should You Close Out Put Credit Spreads?
Like all vertical options spread strategies, you run the risk that the price of the underlying will fall between the short and long strike prices of the spread come expiration.
What’s more, the risk depends on the settlement procedures associated with the asset you’re trading.
Let’s take an asset that is settled in cash, like the SPX and EX for example. There is nothing to worry about.
But that’s not the case if you’re selling 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, for every short put you will be long 100 shares of stock. Typically I wouldn’t see this as being 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 the reality is, you shouldn’t depend on your broker to monitor this for you.
You must monitor your credit spreads that are near expiration to see if you’re potentially at risk for assignment.
Key Things to Remember About Put Credit Spreads
- You make the most money when the underlying asset rallies or stays the same
- Your position is bullish, neutral to 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 put credit spread
- The opposite strategy is a put debit spread
Frequently Asked Questions
Are Credit Spreads Safe?
Credit spreads come with a predetermined risk and reward. There's a maximum amount you can lose. In addition, there is a max amount of profit to be made. In other words, you do hit a profit ceiling which may come into affect if 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 being made off the time value as opposed to the direction the stock is moving.
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 just think of the ability to profit in a market that can't choose a direction.
Do You Let Credit Spreads Expire?
How Do Credit Spreads Make Money?
When implementing a credit spread trade the premium that you paid is less than the premium of the sold option, thus producing a net credit. If the price of the stock stays above or below the short anchor strike before expiration, depending on your strategy, then you get to keep the premium. That's how credit spreads make money.
Maximum Profit = Premium Received
Maximum Loss = Width of Strikes - Premium Received
For the example trade above, the max profit 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 strike price of the short put) then the spread will be a full winner.
