What Is A Credit Spread?
Why Credit Spreads?
Every options trader has a strategy that fits them best, and credit spreads may be what you are looking for! Credit spreads are popular amongst people who want a system that doesn’t require much time in front of the screens compared to other strategies. A credit spread is also a great way to manage risk, as its risk and reward are predefined. If this sounds interesting, keep reading to get more detail on the process from placing the trade to achieving max profit and how this strategy may work for you.
- A credit spread option strategy utilizes the purchase and selling of the same option expiration in the same name on the same side of the option chain to create a credit received.
- To create a credit spread properly, the order must have a strike sold closer to the money than the buy strike price of the same expiration. Additionally, both the bought and sold strikes will be on the same side of the option chain.
- The strategy gets the name “credit spread” rather than “debit spread” due to the net credit of the premium received upon placing the trade.
What is a credit spread?
There are two variations of a credit spread: a bull credit spread and a bear credit spread. Since the position is inherently directional, that will decide which spread you place. You buy and sell the chain’s put side when taking a bull credit spread. When taking a bearish credit spread, you are doing the opposite. Credit spreads are popular because the trade requires much less maintenance and attention than other strategies. Another reason to take a credit spread is to properly manage risk with a predefined max loss and max profit.
Credit Spread Diagram
Call Credit Spread in TastyTrade
Example of credit spread
An example of what a bull credit spread may look like in an alert form looks like this. Sell -1 Vertical SPX 100 (weekly) 21 OCT 22 3620/3600 PUT @3.60. Let’s break down how to read this alert/signal. The -1 is the number of contacts in the transaction. SPX 100 (weekly) 21 OCT 22 is this trade’s expiration date. 3620/3600 PUT are the strikes being sold and bought, with the first number being sold because it is closer to the money than the other. Lastly, @3.60 is the amount of credit received when placing the trade.
How to use a credit spread
The first thing you will want to do when placing a credit spread is identified a directional move on which you are willing to allocate risk. You are essentially betting that the underlying stock price will be below your sold strike if in a vertical put, or above the sold strike in a vertical call, at expiration. Once you have identified a direction, the next step in placing a vertical credit spread is choosing an expiry that fits your trading plan. Once you have selected the expiration date, you will decide to sell the strike price that you are risking against in the underlying stock. For example, if you think that Tesla will close above $220 next Friday, selling the $210 strike for next Friday might make sense, giving yourself some room for error. If the underlying stock is above your puts that you sold at expiration, you will achieve max profit; if the stock is below the calls you sold at expiration, then the max profit will also be achieved.
Why should I use a credit spread?
If you have a thesis on a directional move in the underlying stock, a credit spread allows you to take part in the movement with a predefined risk. Many options strategies are fighting against the greeks in the market, but this strategy uses them in your favor to increase the probability of success within a trade. Ultimately, a credit spread is another way to play a directional move without the difficulties of a naked option.
If you like the idea of directional trading without dealing with the difficulties of a naked option, then a credit spread may be for you. Another reason this strategy is popular is that greeks work in your favor rather than against you as time becomes your friend. When time is your friend, active management is less critical than other strategies.
Credit spreads work by collecting the premium that theta deteriorates out of an option as the expiration date becomes closer. Instead of fighting the greeks, a credit spread works with them.
A credit spread is a great way to take a directional position on the underlying stock without having to be pinpoint accurate. Utilizing a credit spread to give yourself some cushion on your thesis greatly benefits this strategy.
You make money when the spread between the premium on the selected strikes narrows. Premium will narrow between the two strikes as theta kicks in and deteriorates the option strike.