Learn to Trade Options: Simplifying Credit Spreads

Breaking down credit spreads with options guru, Bernie Schaeffer

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    Trading options can be a complicated process as a lot of options strategies are available and traders need to evaluate all of the possible routes ahead of executing a trade. As such, Schaeffer's are starting a new educational series titled Optimizing Your Options Strategies. The beauty of options trading is that there are options strategies for every market environment. In this series, we will cover all available options strategies for an educated trader to consider when identifying trading opportunities.

    In this article, we will be talking about one of the most popular options strategies known as Credit Spreads. Credit spreads are a popular options strategy where, most simply, the trader sells a higher-priced option and buys a lower-priced option of the same stock and same expiry. The strategy uses two options contracts to form a range consisting of a higher strike price and a lower strike price. The trader gets a net credit from the difference between the two premiums from the options.

    The buyer of a credit spread option can profits if the credit spread between two specific benchmarks widens or narrows, depending upon the way the option is written. Credit spreads come in the form of both calls and puts, allowing both bullish and bearish approaches to the strategy.

    There are various different methods for implementing credit spreads and we will further discuss bullish put spreads and bearish call spreads in this article. Regardless of a traders inclination, all credit spreads are designed to make a profit when spreads between the two options narrows.

    The potential profit on a credit spread is limited to the net premium received minus the commissions, and this profit is realized if at expiration both options are out of money and, therefore, both options expire worthless. The goal is for your position to expire worthless.

    The maximum risk when placing a credit spread is equal to the difference between the strike prices minus the net premium received, including commissions.  One example is that the difference between the strike prices is $5.00 ($100.00 – $95.00 = $5.00), and the net premium credit is $1.90 ($3.20 – $1.30 = $1.90). The maximum risk, therefore, is $3.10 ($5.00 – $1.90 = $3.10) per share, minus commissions. This maximum risk is realized if the stock price is at or below the strike price of the long put at expiration.

    To find the credit spread breakeven points for bullish credit spreads, the net premium is added to the lower strike price. For bearish credit spreads, the net premium is subtracted from the higher strike price to breakeven. 

    Bullish Credit Spread Strategies

    Bullish options strategies are chosen when the options trader expects the underlying stock price to increase from the current price. Once a trader has decided he is bullish on a stock, it is necessary to assess how high the stock price could reasonably go in a selected time frame in order to choose the most optimal options trading strategy. When selecting a bullish credit from available options strategies, this should indicate that the trader a moderately bullish prediction. Using credit spreads as an options strategy caps maximum potential profits, but the margin requirement is less for a nominal amount of exposure.

    A bullish put spread is an example of bullish credit spread options strategy. A bullish put spread is when a trader buys an out-of-the-money (OTM) put option and, concurrently, sells a higher strike price put option to receive a net premium credit.

    Bearish Credit Spread Strategies

    Bearish options strategies are employed when a trader expects the underlying stock price to decrease from its current price. It is necessary to assess how much of a decline the stock can reasonably achieve, because bearish credit spreads should only be used for moderately bearish predictions.

    A bearish call spread is an example of a bearish credit spread options strategy. A bearish call spread is when a trader buys an out-of-the-money (OTM) call option and, concurrently, sells a lower at-the-money (ATM) or in-the-money (ITM) call option to receive a net premium credit.

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