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Credit Spreads

Credit Spreads

Credit spreads allow traders to profit in a neutral market or slight directional bias. This strategy requires a margin account as well as a trading account with a larger amount of money.  It might limit the amount of trades that 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 price closes above or below your strike, depending on strategy, by expiration date, then you get to collect the full premium. 

Table of Contents

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.

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 and be correct about it. 

Credit Spreads

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.

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. Read our post on implied volatility and its meaning to learn more about using it to your advantage.

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. 

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. 

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.


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