The credit spread strategy involves buying and selling two options with the same underlying security and expiration date but different strike prices in a way that there is a net inflow of premium.
This simple strategy helps reduce the risks of an open position. This article will discuss the credit spread strategy and how to use it.
The strategy ensures the total inflow of premiums remains positive, hence, the name. The credit spread is further bifurcated as credit call spread and credit put spread. In credit spread, the flow of premium begins with selling an at-the-money option. It possesses the highest time value and attracts the most expensive premium. Following this, the trader buys an out-of-the-money option, which is cheaper.
Call or put credit options strategy selection depends on the market condition. The value of call options increases when the market price rises. Similarly, put options become valuable when market price declines.
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 Rs. 0.50 and sold 10 ABC June calls at Rs. 2 for a net credit of Rs. 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 Rs. 80. At the same time, your short call will be assigned. You will be required to sell 1000 shares for a strike price of Rs. 75. It results in a loss of Rs. 5000. However, you received a premium of Rs. 1500 when you sold the call option, which brings down your loss to Rs. 3500. It will be a scenario if the price moves beyond Rs. 80.
Scenario 2: The stock price rises slightly to close at Rs. 78
In this case, you won’t exercise your rights to buy stocks at Rs. 80. However, your short position will be assigned. You will have to buy 1000 shares at Rs. 7800 to sell at Rs. 7500, resulting in a loss of Rs. 3000. But you have already received Rs.1500, which reduces the actual loss amount to Rs. 1500.
Scenario 3: The share price increase to Rs. 76
The difference of Rs.1000 between buying and selling price gets offset by the Rs. 1500 you brought at the beginning of the trade, resulting in a positive cash flow of Rs. 500.
Scenario 4: The share price falls to Rs. 73
- • You will not exercise your rights to buy shares at Rs. 80.
- • Your short position won’t be assigned because they are out-of-the-money.
You retain Rs. 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
The following are the significant advantages of using a credit spread.
- • The risk reduces substantially when the stock price moves dramatically.
- • The margin requirement is considerably lower than the uncovered options.
- • It limits the loss, which is the difference between the strike prices of the two contracts.
- • It’s self-monitoring and requires less involvement than several other options trading strategies.
- • Usually, spreads are versatile, with various strike prices and expiration dates.
There are two significant disadvantages.
- • When the spread lowers risks, it also reduces your profit potential.
- • 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.
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