Credit Spread Explained

In finance, a credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit. In contrast, an investor would have to pay to enter a debit spread.

For example - One uses a credit spread as a conservative strategy designed to earn modest income for the trader while also having losses strictly limited. It involves simultaneously buying and selling (writing) options on the same security/index in the same month, but at different strike prices. (This is also a vertical spread)

If the trader is BEARISH (expects prices to fall), you use a bearish call spread. It's named this way because you're buying and selling a call and taking a bearish position.

Look at the following example.

Trader Joe expects XYZ to fall from its current price of $35 a share.

Write 10 January 36 calls at 1.10 $1100
Buy 10 January 37 calls at .75 ($ 750)

net credit $350

Consider the following scenarios:

The stock falls or remains BELOW $36 by expiration. In this case all the options expire worthless and the trader keeps the net credit of $350 minus commissions (probably about $20 on this transaction) netting approx $330 profit.

If the stock rises above $37 by expiration, you must unwind the position by buying the 36 calls BACK, and selling the 37 calls you bought; this difference will be $1, the difference in strike prices. For all ten calls this costs you $1000; when you subtract the $350 credit, this gives you a MAXIMUM Loss of $650.

If the final price was between 36 and 37 your losses would be less or your gains would be less. The "breakeven" stock price would be $36.35: the lower strike price plus the credit for the money you received up front.

Traders often using charting software and technical analysis to find stocks that are OVERBOUGHT (have run up in price and are likely to sell off a bit, or stagnate) as candidates for bearish call spreads.

If the trader is BULLISH, you set up a bullish credit spread using puts. Look at the following example.

Trader Joe expects XYZ to rally sharply from its current price of $20 a share.

Write 10 January 19 puts at $0.75 $750
Buy 10 January 18 puts at $.40 ($400)

net credit $350

Consider the following scenarios:

If the stock price stays the same or rises sharply, both puts expire worthless and you keep your $350, minus commissions of about $20 or so.

If the stock price instead, falls to below 18 say, to $15, you must unwind the position by buying back the $19 puts at $4 and selling back the 18 puts at $3 for a $1 difference, costing you $1000. Minus the $350 credit, your maximum loss is $650.

A final stock price between $18 and $19 would provide you with a smaller loss or smaller gain; the breakeven stock price is $18.65, which is the higher strike price minus the credit.

Traders often scan price charts and use technical analysis to find stocks that are OVERSOLD (have fallen sharply in price and perhaps due for a rebound) as candidates for bullish put spreads. Additionally, writing (selling) credit spreads with higher current IV (implied volatility) 50% and higher, will increase the prospects for a profitable trade.

NOTICE IN BOTH cases the losses and gains are strictly limited. This is a nice strategy for earning a modest amount of income from a portfolio that can be used to supplement your wages, dividends, or social security payments as long as you're aware of the limits.

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

Most brokers will let you engage in these defined risk / defined reward trades.

Maximum potential
The maximum gain and loss potential are the same for call and put spreads. Note that net credit = difference in premiums.

Maximum gain
Maximum gain = net credit, realized when both options expire.

Maximum loss
Maximum loss = difference in strike prices - net credit.