Credit Spreads: Explained

Anyone who goes on an introductory course in options trading will no doubt become familiar with credit spreads. This remains one of the most popular trading strategies among traders of all levels for a variety of reasons.

Definition
A credit spread is an options trading spread for which the trader does not have to pay an upfront fee. Instead the trader is actually paid to set up a credit spread! The reason for this is that credit spreads involve selling more expensive options and buying cheaper ones, which means the net premium results in a credit to the trader’s account.

Margin and trading Level

There is a trade-off though: whereas a debit spread does not involve any margin, since the trade can usually not lose more than the net cost to set up the position, a credit spread sometimes has the potential to lose an unlimited amount of money. This results in broker requiring a margin deposit before a trader can set up a debit spread. For stock options a higher trading level is usually also required than for debit spreads.

Benefits of credit spreads

Whereas most debit spreads require the price of the underlying asset to move either up or down in order to profit, credit spreads have the unique ability to profit if the price of the underlying asset remains stagnant or moves in a narrow range.

Although some credit spreads have unlimited potential for loss, there are also many other credit spreads with a limited potential for loss.

While credit spreads require a margin deposit, they still require a smaller margin deposit than naked puts or naked calls. In fact the lower margin involved is one of the reasons why many traders prefer credit spreads over selling naked options.

Although most credit spreads will profit in a stagnant or range-trading market, there are also credit spreads that will profit if the market breaks out either to the upside or the downside.

Examples:

A credit spread for bullish markets

Below is an example of a typical bullish credit spread, the bull put spread. This involves selling ATM put options and simultaneously buying OTM put options for the same expiration date.


A credit spread for bearish markets

Below is an example of a credit spread for a bearish market. The bear call is set up by selling ATM call options and simultaneously buying the same number of OTM call options for the same expiration date.


A credit spread for neutral markets

If a trader believes the market will remain either stagnant or range-bound until the expiration date he or she can’t do much better than a credit spread specifically intended for neutral markets. One such example is the very popular iron condor, which consists of selling OTM calls and OTM puts while simultaneously buying further OTM calls and puts which are cheaper.

Fig. 9.28(d) is an example of a typical iron condor credit spread.


A credit spread for volatile markets

If it is highly likely that the price of the underlying asset will break out either to the upside or the downside, a trader should opt for a credit spread designed specifically to benefit from this situation. An example in this regard is the ever popular short butterfly spread that is illustrated below in Fig. 9.28(e).


This trade is set up by buying two ATM call options and simultaneously selling an OTM call and an ITM call. The higher premium income from the ITM call helps to more than offset the cost of the ATM calls, creating a net credit.

Conclusion

While credit spreads can be ideal under certain circumstances, one always has to take into account a) the probability of the trade actually realising a profit and b) whether the maximum risk/maximum profit payoff justifies the trade.