Trader's Guide to Credit Spreads
Updated
The strategies and ideas presented in this guide have been designed to provide you with a comprehensive program of learning. The goal is to guide you through the learning experience so you may be an independent, educated, confident and successful trader. There are numerous variations of traditional options strategies and each has a desired outcome. Some are very risky strategies and others require a considerable amount of time to find, execute and manage positions. Spreads are a limited risk strategy.
Spreads
Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes.
Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias).
Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the same anticipated move down.
In this guide we will be talking about Credit Spreads, which are a limited risk strategy. Learning how to manage risk is as important as learning the details of a strategy.
Credit Spreads
A credit spread is created when an investor simultaneously sells-to-open (STO) one option and buys-to-open (BTO) another option. The premium received for the STO is always greater than the premium paid for the BTO thus creating a net credit to the account.
Example:
The ideal construction of a credit spread is to sell-to-open (STO) an out-of-the-money (OTM) strike and buy-to-open (BTO) the strike that is 5 – 10 points further out-of-the-money (OTM) using the same expiration. When opening a call credit spread, further OTM means a higher strike. When opening a put credit spread, further OTM means a lower strike.
Both legs are opened on the same underlying equity and use the same expiration month.
Call credit spreads are opened when there is a declining bias and will be profitable if the stock moves down. This is because a call credit spread is opened for a credit and since the value of a call option decreases as the stock goes down, at some point the spread will be bought-to-close (BTC) for less than it was sold-to-open (STO).
Here is an example:
Stock trading at 500 and has a declining bias.
This spread creates a credit of $4.80
Stock declines to 490 causing the values of the calls to also decline. The position can now be closed for a profit.
The cost to buy back the spread is only $3.80. Since the stock declined in value, the call options are cheaper.
The spread was STO for a credit of $4.80 and BTC for a debit of $3.80 resulting in a $1.00 profit.
Put credit spreads are opened when there is a rising bias and will be profitable if the stock moves higher. This is because a put credit spread is opened for a credit and since the value of a put option decreases as the stock goes up, at some point the spread will be bought-to-close (BTC) for less than it was sold-to-open (STO).
Here is an example:
Stock trading at 520 and has a rising bias.
This spread creates a credit of $3.60
Stock rises to 530 causing the values of the puts to decline. The position can now be closed for a profit.
The cost to buy back the spread is only $1.80. Since the stock went up in value, the put options are cheaper.
The spread was STO for a credit of $3.60 and BTC for a debit of $1.80 resulting in a $1.80 profit.
Time decay is a positive factor in trading credit spreads. Since the position is opened for a credit, money comes into the traders account immediately. As time value decays, combined with a favorable movement of the stock, the value of the position will decrease allowing the trader to buy-to-close (BTC) the position for less than it was originally sold-to-open (STO).
Risk and Reward on Credit Spreads
Reward
The maximum profit that can be earned from a credit spread is equal to the net credit received when the spread was opened. For a credit spread to realize the maximum profit, both legs of the spread would need to expire worthless which means the position would need to be held until expiration and be out-of-the-money at expiration.
It is not advised to hold positions until expiration. Short term movements in the stock plus time value decay provide opportunities to close out positions for a profit of, generally, about 10%. If a position is profitable and the trader decides to hold the position hoping for a bigger profit or in an attempt to carry the position to expiration, there is a good chance that the profit can disappear, and the position could turn into a losing position.
A good way to lose money is to wait for a bigger profit.
Risk
The maximum risk, or potential loss, from a credit spread is the difference between the two strikes minus the net credit.
Example:
Spreads
Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes.
Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias).
Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the same anticipated move down.
In this guide we will be talking about Credit Spreads, which are a limited risk strategy. Learning how to manage risk is as important as learning the details of a strategy.
Credit Spreads
A credit spread is created when an investor simultaneously sells-to-open (STO) one option and buys-to-open (BTO) another option. The premium received for the STO is always greater than the premium paid for the BTO thus creating a net credit to the account.
Example:
- STO a call using the 120 strike for a credit of $5.20
- BTO a call using the 130 strike for a debit of $3.80
- Net credit for the spread is $1.40 = 5.20 credit - 3.80 debit
The ideal construction of a credit spread is to sell-to-open (STO) an out-of-the-money (OTM) strike and buy-to-open (BTO) the strike that is 5 – 10 points further out-of-the-money (OTM) using the same expiration. When opening a call credit spread, further OTM means a higher strike. When opening a put credit spread, further OTM means a lower strike.
Both legs are opened on the same underlying equity and use the same expiration month.
Call credit spreads are opened when there is a declining bias and will be profitable if the stock moves down. This is because a call credit spread is opened for a credit and since the value of a call option decreases as the stock goes down, at some point the spread will be bought-to-close (BTC) for less than it was sold-to-open (STO).
Here is an example:
Stock trading at 500 and has a declining bias.
- STO 510 call
- BTO 520 call
This spread creates a credit of $4.80
Stock declines to 490 causing the values of the calls to also decline. The position can now be closed for a profit.
- BTC 510 call
- STC 520 call
The cost to buy back the spread is only $3.80. Since the stock declined in value, the call options are cheaper.
The spread was STO for a credit of $4.80 and BTC for a debit of $3.80 resulting in a $1.00 profit.
Put credit spreads are opened when there is a rising bias and will be profitable if the stock moves higher. This is because a put credit spread is opened for a credit and since the value of a put option decreases as the stock goes up, at some point the spread will be bought-to-close (BTC) for less than it was sold-to-open (STO).
Here is an example:
Stock trading at 520 and has a rising bias.
- STO 510 put
- BTO 500 put
This spread creates a credit of $3.60
Stock rises to 530 causing the values of the puts to decline. The position can now be closed for a profit.
- BTC 510 put
- STC 500 put
The cost to buy back the spread is only $1.80. Since the stock went up in value, the put options are cheaper.
The spread was STO for a credit of $3.60 and BTC for a debit of $1.80 resulting in a $1.80 profit.
Time decay is a positive factor in trading credit spreads. Since the position is opened for a credit, money comes into the traders account immediately. As time value decays, combined with a favorable movement of the stock, the value of the position will decrease allowing the trader to buy-to-close (BTC) the position for less than it was originally sold-to-open (STO).
Risk and Reward on Credit Spreads
Reward
The maximum profit that can be earned from a credit spread is equal to the net credit received when the spread was opened. For a credit spread to realize the maximum profit, both legs of the spread would need to expire worthless which means the position would need to be held until expiration and be out-of-the-money at expiration.
It is not advised to hold positions until expiration. Short term movements in the stock plus time value decay provide opportunities to close out positions for a profit of, generally, about 10%. If a position is profitable and the trader decides to hold the position hoping for a bigger profit or in an attempt to carry the position to expiration, there is a good chance that the profit can disappear, and the position could turn into a losing position.
A good way to lose money is to wait for a bigger profit.
Risk
The maximum risk, or potential loss, from a credit spread is the difference between the two strikes minus the net credit.
Example:
- STO 120 call for a credit of $5.20
- BTO 130 call for a debit of $3.80
- Net credit for the spread is $1.40
The difference between the strikes is 10 points. $10 is the max risk less $1.40 credit = risk of $8.60. The maximum profit is equal to the net credit, $1.40.
Losses occur when the short strike (the STO leg) is in-the-money at expiration. This is because the trader has sold to someone else the right to buy the stock at the short leg strike. Since the trader does not actually own the stock, they will need to buy it and sell it at a loss.
A maximum loss will occur when both strikes are in-the-money at expiration.
The breakeven point on a bearish (call) credit spread is the lower strike price plus the net credit. Referring to the example above, if the stock settled at 121.40 at expiration, there would be no loss and no profit.
Example of breakeven point on above credit spread:- Stock trading at 121.40
- Buyer exercises the right to buy stock from you at 120.
- Since you do not own the stock, you buy it at the market price of 121.40 and sell it at 120. This results in a $1.40 loss
- You get to keep the original credit of $1.40. This netted against the $1.40 loss results in breaking even on the position.
The breakeven point on a bullish (put) credit spread is the higher strike price minus the net credit.
Calculating the Return
There are two ways to view the percentage return of profits from a credit spread. One is to divide the profit by the difference between the strikes. If the difference between strikes is 10 points and the trade resulted in a $1.00 profit, that would be a 10% return ($1.00 / 10).
The second approach is to calculate the return based on the amount of capital that was at risk. After all, if the trade lost 100% of the risk, that is the amount the trader would no longer have. So, the profit percent is calculated by dividing the profit by the risk. In the example above, the net risk is $8.60. If the credit spread trade resulted in a $1.00 of profit, the percentage return would be 11.63% ($1.00 / $8.60). This approach shows the importance of managing risk. Lower risk drives higher returns relative to capital at risk.
Opening a new Call Credit SpreadThe following steps should be referred to when opening a new call credit spread position:1. Review the technical indicators on your chart and confirm there is a consensus between multiple indicators pointing to a declining bias.
2. Select an expiration that is two to four weeks out. Two weeks is generally the minimum time to expiration you want to use. Building time into options positions is advised in case it needs to be managed. The sweet spot for opening new positions is three weeks to expiration. 3. STO an out-of-the-money (OTM) call strike.
4. BTO the strike that is 5-10 points further out-of-the-money (OTM). With a call spread, further OTM means a higher strike. Generally, when properly constructed, the credit on a 5 point spread will be in the range of $1.20 - $1.80. A 10 point spread will generally be 2.50 – 3.50. The closer the strikes are to the current price, the higher the credit, while this reduces the overall risk of the position, it also increases the chances of the position moving in-the-money (ITM) which can result in an overall loss.
5. When placing the order, always use a Limit Order. A limit credit order specifies to the market the amount of the credit you will accept. A limit credit order will be filled at the specified limit or higher. Market orders should not be used.
6. With some stocks and indexes, the difference between the bid and ask is quite large. The broker will usually give you a quote called the “Mark”. This is the midpoint between the bid and ask. It is the price you should start with when submitting your limit credit order.
7. Calculate the risk of the position. Difference between the strikes – credit = risk. A position with a credit of $4.50 and 10 points between the short (sold) and long (buy) strikes would have a risk of $5.50.
8. Use the risk number to determine the number of contracts to open. Risk x 100 = the investment required for each contract. With $5.50 of risk and 1 contract, the total investment would be $550. ($5.50 x (1 contract x 100 shares per contract)). The total investment on 4 contracts would be $2,200. ($5.50 x(4 contracts x 100 shares per contract)).
9. Once you know the total investment required per contract, you can decide how many contracts to trade based on the size of your portfolio and personal risk tolerance.
10. After the trade has been opened, place a Good-til-Canceled (GTC) order to close the position. A GTC order will stay active until market conditions are such that the position can be closed for a profit. GTC orders execute automatically and do not require you to be in front of your trading platform to take advantage of the profit opportunity. Place the GTC for a limit debit price based on your desired profit target. One example is to set a GTC for 50% of the credit you received when you opened the position. With a credit of $4.50, a GTC would be placed to buy to close the position at $2.25 allowing a $2.25 profit.
- Stock trading at 121.40
Note
It should be noted that Credit Spreads on American Style expirations should generally not be held overnight if they are in-the-money, as they can run the risk of exercise/assignment. Ideally the out-of-the-money credit spread should be closed or managed before the week of expiration. This will limit the risk of any exercise/assignment.One way to completely eliminate the risk of exercise/assignment on credit spreads is to trade European Style expirations on the cash indexes (SPX, RUT, NDX) and never hold until expiration. As mentioned in our Trader's Guide to Options, European Style options may only be exercised or assigned at expiration.
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