The Trader's Guide To Credit Spreads

Introduction

There is no doubt that some life choices are pretty easy, such as how you put on your jeans. This is because you are most likely to go with the usual fly-in-the-front, one-leg-at-a-time method, as it is the obvious choice. However, keep in mind that if you trade options, things can get complicated.

This is because not only do you have to know whether you think or believe a stock will go down or up, but you need to consider volatility as well.

Did you know that this is where many options traders, especially beginners, get hung up on strategy? Which options spread do you go with once you’ve the information that you need? If you would like to determine your profit potential as well as exactly how much money you are risking before you place an options trade, credit spreads can be ideal for you.

There are many option spread strategies that you could employ when trading or investing in options. Note that a spread involves the purchase and sale of different options on the same underlying asset as a package.

We can define credit spreads, also called net credit spreads, as spread strategies that entail net receipts of premiums. On the other hand, debit spreads involve net premium payments. So, credit spreads are an options trading strategy where you simultaneously purchase and sell options that are of the:

• Same expiration date
• Same class (calls or puts)
• But with different strike prices

As you can see, credit spreads have many useful characteristics. For example, they can be an immensely valuable risk management tool for many options traders. This is because credit spreads allow you to considerably limit risk by forgoing or giving up a limited amount of profit potential. 

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Explanation of Credit Spreads

As an options trader, what do you do if you think that an underlying asset or stock will not most likely go higher but do not feel confident or assured that the underlying stock will drop much or vice versa? You may know that without using options, it can be difficult to make a profit from that scenario. However, using options, credit spreads in particular, you can.

A credit spread is a unique option spread strategy where the premiums you receive from the short leg of the spread are higher than the premiums you pay for the long leg.

This results in funds being credited into your trading account when you enter the position. Keep in mind that the credit received (net) is also the profit attainable (maximum) when you implement the credit spread options strategy. You can use credit put spreads (also known as bull put spreads) to profit when you are expecting the underlying asset to stay above a specific value.

It is worth noting that the buyer of credit spreads option can receive cash provided the credit spread between 2 specific benchmarks narrows or widens. This depends on how the option is written. The best thing is that credit spread options are available in the form of both puts and calls. This allows long and short credit positions.

What are Credit Put Spreads

You should know that the credit put spread options strategy is a neutral, bullish, and minimally bearish trading strategy. This strategy has limited profit potential. Note that essentially, this strategy entails selling a put option and simultaneously purchasing a put option further away from your short put.

The put credit spread is often known as a “bull put spread.” And credit put spreads are an excellent way to sell option premium while avoiding a potentially catastrophic loss that’s a constant and major risk with short options. You can use a credit put spread instead of an outright sale of your uncovered put options.

Keep in mind that selling uncovered put options is a bullish trade, and you can use it when you expect an underlying asset or security to move upward. In many cases, the goal is to generate income when selling the uncovered put option and then to wait until that option expires worthless.

Bull Put Spread Payoff Diagram

Did you know that investors usually use put options in order to profit from declines in a stock's price? This is because a put option gives you the ability or opportunity—but not the obligation—to sell a stock either before or at the expiration date of the option contract.

Effects of changes in Volatility

It is worth noting that since bull put spreads consist of one long put and one short put, the price of your bull put spread will change very little when there is a change in volatility, and other factors stay constant.

In the terminology of options trading, this is called a “near-zero vega.” And vega is an estimate of how much the option price changes or fluctuates as the volatility level changes while other factors remain unchanged.

Impact of Time

As a bull put spread comprises one long put and one short put, note that the sensitivity to time erosion often depends on the relationship between the stock price and the strike prices of the option spread. This means that if the stock price is above or close to the strike price of your short put (or higher strike price), the price of your bull put spread decreases (and hence makes money) with the passage of time. This happens as the short put is usually closest to the money and consequently erodes considerably faster than the long put.

On the other hand, if the stock price is about halfway between the two strike prices, time erosion has little to no effect on the price of your bull put spread. This is simply because both the long put and short put erode at about the same rate.

What are Credit Call Spreads

Did you know that you can use a credit call spread instead of an outright sale of your uncovered call options? You can use credit call spreads (also called bear call spreads) to profit when you are expecting the underlying asset or stock to stay below a certain price.  

Selling of uncovered call options is a bearish trade that you can use when you expect an underlying asset or security to move downward. And usually, the goal is to generate income when you sell the uncovered call option, waiting until your option expires worthless.

Keep in mind that when you create a bearish position with a credit call spread, the premium that you pay for the option bought is lower compared to the premium you get from selling the option. This is why you still generate income when this position is established but lower than you would do with an uncovered position.

Bear Call Spread Payoff Diagram

You should know that the mechanics of credit call spreads are almost the same as those of credit put spreads; however, you will find the profit and loss regions on opposite sides of the break-even point.

There is no doubt that the main benefit of a bear call spread is that you can reduce the net risk of the trade. This is because buying the call option that has the higher strike price can offset the risk of selling the call option that has the lower strike price.

Also, it carries considerably less risk than shorting the security or stock as the maximum loss is usually the difference between the 2 strike prices reduced by the amount credited or received when the option trade is initiated. We can say that selling a stock short theoretically carries unlimited risk if the stock or security moves higher.

Effects of changes in Volatility

You probably know that as volatility increases, option prices usually increase if other factors or variables, such as time to expiration and stock price, remain constant. And as a bear call spread comprises one long call and one short call, typically, the price of a call spread changes extremely little when there is a change in volatility, and other factors stay constant.

Breakeven Point

Impact of Time

As a bear call spread comprises one short and one long call, usually, the sensitivity to time erosion will depend on the relationship between the stock price and the strike prices of your spread.

So, if the stock price is above or close to the strike price of your long call (or higher strike price), the price of the call spread increases (losing money) with the passage of time. And this happens as the long call is much closer to the money, eroding faster than the short call.

The Best Time to Consider a Call Credit Spread

It is no secret that call credit spreads are excellent trades to place if you would like to take advantage of time decay while limiting the maximum potential loss for the position. And this is truly where the call credit spread options trading strategy shines.

Keep in mind that if the underlying security or asset increases slightly, the position will likely make money. This will also depend on how far out of the money (OTM) the credit spread is. So, if the underlying stock or asset does not move at all, then the position will make money.

If you believe that the underlying stock or asset will fall by a limited amount from the trading date to the expiration date, a bear call spread is usually an ideal play. 

Advantages and Drawbacks of Spreads

Credit spreads have advantages and drawbacks compared to selling uncovered options. The reason many credit spread traders like this options trading strategy is because they can design the trade to have a higher probability of profits.

Benefits of Credit Spreads

• Credit spreads can lower your risk considerably if the stock or asset moves severely against you.
• The margin requirement is considerably less compared to uncovered options.
• The spread is more flexible and versatile. This means that as an investor, you get plenty of options with respect to the strike prices as well as expiration dates.
• You cannot lose more funds than the margin requirement held in your trading account at the time you establish the position. On the other hand, with uncovered options, you may lose considerably more money than the initial margin requirement.
• In many cases, credit spreads require less monitoring compared to some other kinds of options strategies. This is because once established, they are often held until expiration. You should, however, review spreads occasionally in order to determine if holding them until the expiration date is still warranted. For instance, if the underlying stock or instrument moves far and quickly enough, you might be in a position to close out the spread position at a reasonable net profit prior to the date of expiration.

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Disadvantages of Credits Spreads

The main disadvantage of credit spreads is that they still require that you trade on margin. And that is not something you have to do if you’re straight up purchasing options contracts.

• Your profit potential will likely be reduced by the amount you spend on the long option leg of the credit spread.
• As a spread requires 2 options, the commission is generally higher than one uncovered position.

Final Thoughts 

Like with everything in options trading, there are some risk/reward trade-offs of using credit spreads. While you may risk more than the profit potential, it comes with a higher probability of success. You may know that recent years have seen some dramatic volatility events, especially because of the COVID-19 pandemic. These caused painful and considerable losses for some options traders who sold options in order to generate income.

Although credit spreads, both credit put and call spreads, include a built-in hedge, you should know that they usually work better in times of certainty. This is why when volatility slams the whole market, certain patterns and trends stop working. Support levels do not hold, and ranges widen, throwing a huge monkey wrench in a probability-based options trading system. 

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