What is a Credit Spread: Things To Know
When option traders come across situations when they think that an underlying isn’t likely to shoot up but they aren’t sure if it will drop either, it’s not a position of clarity. Unless you use options, and a credit spread in particular, you can’t really benefit from that scenario. Let’s find out what credit spreads are and how they work.
Credit Spread: Key Aspects
What is a credit spread?
Call credit spreads (bear call spreads) are an extremely effective way to book profits in a situation where the options trader is expecting the underlying to stay below a certain area. On many occasions, this area is potential resistance manifests in the form of pivot levels or a moving average. Put credit spreads (bull put spreads) are an extremely effective way to book profits when the options trader expects the underlying to stay above a certain area, which is potential support on many occasions. In addition, the overall market might look less bullish or less bearish and/or including the underlying. Let’s find out how to implement this trading strategy.
When should you call a credit spread?
A call credit spread — or as it is sometimes called, a bear call spread — is created by selling a call option and buying a higher strike call with the same expiration. Maximum profit is the term used to describe the credit received and it is earned by the trader when the options expire worthless (at or below the short strike at expiration). The maximum risk on the trade subtracting the premium is generated as a result of the difference in the strikes. The breakeven point adds the credit received to the short strike. Let’s take a quick look at a recent potential opportunity where a bear call might have been considered.
When Visa Inc. (V) was trading around the $186 level in November, the chart looked like this (see below).
At the time, there were some pivot levels that had acted like resistance around the $190 level and the daily 200-day moving average. The stock might have a difficult time closing back above that level especially if the trend continued lower. A 190/195 bear call spread with less than a week to go until expiration could have been sold for about 1.34 (2.25 – 0.91).
The $1.34 (or $134 in real terms) represents the maximum profit that could have been earned if the stock stayed at or below the $190 level at expiration. The maximum risk was $3.66 (5 (difference in the strikes – 1.34 (premium)) or $366 in real terms) if the stock closed at $195 or higher at expiration. Breakeven would be at $191.34 (190 + 1.34 (premium)) at expiration. The stock could move lower, trade sideways or rally up to $190 by expiration and still the maximum profit could have been earned and the options expire worthless. That gives the trade three out of four ways to potentially profit.
How are credit spreads like insurance?
If you observe the example mentioned above, the long 195 call strike kept the position from potentially losing a significant amount. The risk on a short call option can go up to infinity. However, it isn’t very likely. However, if the underlying blasts through the short strike, the long call option acts in a similar manner to insurance since the owner has the right to buy shares at $195 in this example up until expiration. In case the stock keeps climbing past $195 at expiration, the maximum loss is locked in, regardless of the stock’s climb.
What Are Short-Term Credit Spreads?
As the Visa example explained, credit spreads generally do very well with shorter expirations. There are two main reasons behind that. First, a shorter expiration results in a larger positive or negative delta. A move lower by the underlying for a call credit spread that has negative delta will decrease the premium at a faster rate. That bodes very well for booking potential profit. A put credit spread will have a positive delta so a move higher is bound to be helpful in such scenarios.
Second, shorter OTM (out-of-the-money) credit spreads chrome with higher positive thetas. These bring the option premium down at a much faster rate, as they have larger positive thetas. So, if option traders see an opportunity for a short-term credit spread and the premium makes sense, delta and theta could serve as extra bonus.
Hopefully, you now have a better idea of credit spreads after reading this post. While options trading seems highly lucrative, you should always remember the risk/reward trade off. Trading options comes with an incredible profit potential and a high probability of success. However, the amount of risk involved is also significantly higher. So exercise caution when you trade using options.