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The credit spread strategy is one of the most popular and simple approaches in options trading which allows traders to manage risks and earn steady income. It involves buying and selling two options on the same stock or index with the same expiry date but different strike prices. The objective of this approach is to create a net inflow of premium. This means you receive more money than you pay out.
This strategy is designed to limit both profit and loss, making it safer than holding a single open position. There are two main types, call credit spread and put credit spread. In a credit spread, traders usually sell an at-the-money option to earn a higher premium and buy a cheaper out-of-the-money option to reduce risk. The choice between call or put depends on your analysis of if the market will rise or fall.
Key Takeaways
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A credit spread means selling one option and buying another with the same export but different strike prices. This offers limited profit and loss.
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Call credit spread is used when prices fall whereas put credit spread is used when prices rise.
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There are controlled losses as the maximum you can lose is the gap between strike prices minus the premium you receive.
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There is low risk and margin. And also small profit and high fees.
What Is a Credit Spread Option?
Credit spread options are a type of financial tool used in options strategies to manage and reduce credit risk. It works by buying and selling options with different strike prices on the same asset. As a result of this, traders can take advantage of changes in credit spreads. This is the difference between two interest rates or benchmark yields. The value of these options depends on how big or small the spread becomes over time. For investors and risk managers, credit spread options are an ideal way to avoid potential losses or to earn steady income when market conditions change. They are often used to control risk in a portfolio and to make the most of expected movements in credit markets. Overall, with this approach, traders are in a better position to manage uncertainty, limit risk, and make profit from predictable price or interest rate differences in the financial market.
How Credit Spread Options Work
Credit spread options in the stock market involve strategies that capitalise on changes in the difference (spread) between the premiums of two related options. One with a higher and one with a lower strike price, on the same underlying asset, such as a stock or an index. Investors use these strategies to manage risk, generate income, or hedge against market volatility. A bullish credit spread (credit put spread) earns a premium when the market stays above a certain level, while a bearish credit spread (credit call spread) profits if the market remains below a specific price.
The buyer or seller of a credit spread option benefits depending on whether the spread between the option prices widens or narrows with market movement. These strategies allow traders to define risk and reward precisely, making them practical tools for managing exposure in equity and index options without the high capital requirements of outright positions.
Call Options Credit Spread Strategy
Instead of opting for an uncovered call option, traders can use a call credit spread strategy to limit risk.
Selling an uncovered call option is a bearish strategy where traders expect the underlying security or index to move downward. It involves generating income by selling an uncovered call and then waiting until the option expires worthless. When you apply a credit spread strategy in the bearish market, the premium you pay for the contract you buy is lower than the premium you receive from selling an at-the-money call option, resulting in a positive cash flow premium. As a result, you still profit from the trade, but it is lower than what you would make in case of an uncovered call.
Here are different situations that can arise in a call spread strategy.
Let’s say you bought 10 ABC 80 June calls at ₹0.50 and sold 10 ABC June calls at ₹2 for a net credit of ₹1.50.
Scenario 1: The stock price rises significantly above the strike price of the option you bought.
In this case, you will exercise your right to buy the 1000 shares at the strike price of₹80. At the same time, your short call will be assigned. You will be required to sell 1000 shares for a strike price of ₹75. It results in a loss of Rs. 5000. However, you received a premium of ₹1500 when you sold the call option, which brings down your loss to ₹3500. It will be a scenario if the price moves beyond ₹80.
Scenario 2: The stock price rises slightly to close at ₹78
In this case, you won’t exercise your rights to buy stocks at ₹80. However, your short position will be assigned. You will have to buy 1000 shares at ₹78000 to sell at ₹75000, resulting in a loss of ₹3000. But you have already received ₹1500, which reduces the actual loss amount to ₹1500.
Scenario 3: The share price increase to ₹76
The difference of ₹1000 between buying and selling price gets offset by the ₹1500 you brought at the beginning of the trade, resulting in a positive cash flow of ₹500.
Scenario 4: The share price falls to ₹73
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You will not exercise your rights to buy shares at ₹80.
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Your short position won’t be assigned because they are out-of-the-money.
You retain ₹1500 that you brought at the initiation of the spread.
Credit Put Spread
A credit put spread is used in place of the uncovered put strategy.
The uncovered put is a bullish strategy when you expect the underlying security or the index to move upwards. The downside risk of a naked put is not unlimited but substantial. A vertical credit put spread involves buying and selling two put options of the same underlying securities and expiration dates but different strike prices.
When you establish a bullish position using a credit spread, the premium you pay for buying an option is lower than the contract you sell. As discussed above, it helps you generate a profit or reduce loss under different market conditions.
Similar to the call credit spread, a put credit spread strategy is useful under different circumstances. The maximum loss value can’t exceed the strike price difference between the two options.
The Credit spread has several valuable characteristics, like reducing risks. Credit spread helps in significant risk reduction by forsaking a limited profit potential. By opting for this strategy, you can calculate the amount of money you are risking before entering the trade.
Advantages and Disadvantages of Credit Spread Strategy
Advantages
The following are the significant advantages of using a credit spread.
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The risk reduces substantially when the stock price moves dramatically.
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The margin requirement is considerably lower than the uncovered options.
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It limits the loss, which is the difference between the strike prices of the two contracts.
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It’s self-monitoring and requires less involvement than several other options trading strategies.
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Usually, spreads are versatile, with various strike prices and expiration dates.
Disadvantages
There are two significant disadvantages.
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When the spread lowers risks, it also reduces your profit potential.
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Traders need to keep in mind the fees that need paying. Since it involves two options, the expenses are higher.
The Bottom Line
It is a simple yet effective strategy that even a new trader can use. The profit and loss in this strategy are pre-determined and limited. Credit spread strategy can be used in any market condition regardless of market price movement.