Credit Spreads Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Good Choice For Experienced Traders! 2nd place in the ranking!

Reducing Risk with a Credit Spread Options Strategy

Would you like to determine your profit potential and exactly how much money you’re risking before placing an options trade? If so, credit spreads may be for you.

Credit spreads are an options strategy where you simultaneously buy and sell options that are of the:

  • Same class (puts or calls)
  • Same expiration date
  • But with different strike prices

Credit spreads have a number of useful characteristics. As mentioned, they can be a helpful risk management tool for options traders. Credit spreads allow options traders to substantially limit risk by forgoing a limited amount of profit potential. In most cases, you can calculate the exact amount of money that you’re risking at the time you enter the position.

Credit spreads are also versatile. Most traders are able to find a combination of contracts to take a bullish or bearish position on a stock by establishing either a:

  • Credit put spread: A bullish position with more premium on the short put.
  • Credit call spread: A bearish position with more premium on the short call.

Now, let’s discuss each strategy in more detail.

Credit put spreads

A credit put spread can be used in place of an outright sale of uncovered put options.

The sale of an uncovered put option is a bullish trade that can be used when you expect an underlying security or index to move upward. The goal is usually to generate income when the uncovered put option is sold, and then to wait until the option expires worthless. Although the downside risk of uncovered puts is not quite unlimited, it is substantial, because you could lose money until the stock drops all the way to zero.

Credit spreads involve the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying security. In the case of a vertical credit put spread , the expiration month is the same, but the strike price will be different.

When you establish a bullish position using a credit put spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position. Let’s look at an example.

Credit put spread example:

  • Buy 10 XYZ May 65 puts @ .50
  • Sell 10 XYZ May 70 puts @ 2 for a net credit of 1.50

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Good Choice For Experienced Traders! 2nd place in the ranking!

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes above $68.50 at expiration. You will maximize your profit ($1,500) at $70 or above. You will lose money if the price of XYZ goes below $68.50, and you could lose up to $3,500 if XYZ closes at $65 or below at expiration. (Commissions, taxes and transaction costs, which are not included in this example, can affect final outcome and should be considered. For the tax implications involved in these strategies, please speak with a tax advisor.)

Source: Schwab Center for Financial Research

If you had sold the May 70 puts uncovered, you would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced $500 profit potential is the ability to limit risk significantly. If you simply sold the May 70 puts uncovered, your loss potential essentially would have been $68,000 ($70,000 loss on the stock, less $2,000 premium received on the sale of the puts) if XYZ were to drop all the way to zero. In the case of this credit spread, your maximum loss cannot exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit put spreads work

To better understand the profit and loss characteristics of credit put spreads, let’s examine five different price scenarios based on the chart above. We’ll assume that once this spread is established, it’s held until expiration. (As a reminder, commissions, taxes and transaction costs are not included in these scenarios.)

  • Scenario 1: The stock drops significantly and closes at $62 on option expiration. If this happens, you will exercise your 65 puts and sell short 1,000 shares of XYZ stock for $65,000. At the same time, your short 70 puts will be assigned, and you will be required to buy back your short position for $70,000 to close. The difference between your buy and sell price is -$5,000. However, because you brought in $1,500 when the spread was established, your net loss is only $3,500. This will be the case at any price below $65. Therefore, this spread is only advantageous over uncovered puts if XYZ drops below $64.50.
  • Scenario 2: The stock drops only slightly and closes at $67 on option expiration. If this happens, you won’t exercise your 65 puts, because they’re out of the money. However, your short 70 puts will be assigned, and you’ll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $67, for $67,000. The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500 at prices from $68.50 down to $65.
  • Scenario 3: The stock closes at exactly $68.50 on option expiration. If this happens, you will not exercise your 65 puts, because they’re out of the money. However, your short 70 puts will be assigned, and you’ll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $68.50, for $68,500. The difference between your buy and sell price results in a loss of $1,500. However, since you brought in $1,500 when the spread was established, your net loss is actually zero.
  • Scenario 4: The stock rises only slightly and closes at $69 on option expiration. If this happens, you won’t exercise your 65 puts, because they’re out of the money. However, your short 70 puts will be assigned, and you’ll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $69 for $69,000. The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, your net gain is actually $500. This gain will vary from zero to $1,500 at prices from $68.50 up to $70.
  • Scenario 5: The stock rises substantially and closes at $72 on option expiration. If this happens, you won’t exercise your 65 puts, because they are out of the money. Your short 70 puts won’t be assigned, because they’re out of the money as well. In this case, all of the options expire worthless and no stock is bought or sold. However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices above $70.

As you can see from these scenarios, using credit put spreads works to your advantage when you expect the price of XYZ to rise, which will result in a narrowing of the spread price or, ideally, both options expiring worthless.

Credit call spreads

A credit call spread can be used in place of an outright sale of uncovered call options.

The sale of an uncovered call option is a bearish trade that can be used when you expect an underlying security or index to move downward. The goal is usually to generate income when the uncovered call option is sold, and then wait until the option expires worthless. When you establish a bearish position using a credit call spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position.

The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread, except the profit and loss regions are on opposite sides of the break-even point, as shown below. Let’s look at an example.

Credit call spread example:

  • Buy 10 XYZ May 80 calls @ .50
  • Sell 10 XYZ May 75 calls @ 2 for a net credit of 1.50

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes below $76.50 at expiration. You will maximize your profit at or below $75. You will lose money if the price of XYZ goes above $76.50, and you could lose up to $3,500 if XYZ closes at $80 or above at expiration.

Source: Schwab Center for Financial Research

If you had sold the May 75 calls uncovered, you would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced $500 profit potential is the ability to limit risk significantly. If you had simply sold the May 75 calls uncovered, your loss potential would have been virtually unlimited if XYZ were to rise substantially. In the case of this credit spread, your maximum loss cannot exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit call spreads work

As we did with the credit put spread, let’s examine five different price scenarios in light of the chart above to draw a clearer picture of how a credit call spread can work. We’ll assume that once this spread is established, it’s held until expiration.

  • Scenario 1: The stock rises significantly and closes at $83 on option expiration. If this happens, you will exercise your 80 calls and acquire 1,000 shares of XYZ at a cost of $80,000. At the same time, your short 75 calls will be assigned, and you’ll be required to sell 1,000 shares of XYZ for $75,000. The difference between your buy and sell price results in a loss of $5,000. However, you brought in $1,500 when the spread was established, so your net loss is only $3,500. This will be the case at any price above $80. Therefore, this spread is only advantageous over uncovered calls if XYZ rises above $80.50.
  • Scenario 2: The stock rises only slightly and closes at $78 on option expiration. If this happens, you won’t exercise your 80 calls, because they’re out of the money. However, your short 75 calls will be assigned, and you’ll be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at the market price of $78, at a cost of $78,000. The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500 at prices from $76.50 up to $80.
  • Scenario 3: The stock closes at exactly $76.50 on option expiration. If this happens, you won’t exercise your 80 calls, because they’re out of the money. However, your short 75 calls will be assigned, and you will be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,500. The difference between your buy and sell price results in a loss of $1,500. However, because you brought in $1,500 initially when the spread was established, your net loss is actually zero.
  • Scenario 4: The stock drops only slightly and closes at $76 on option expiration. If this happens, you won’t exercise your 80 calls, because they’re out of the money. However, your short 75 calls will be assigned, and you’ll be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,000. The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, you actually have a net gain of $500. This gain will vary from zero to $1,500 at prices from $76.50 down to $75.
  • Scenario 5: The stock drops substantially and closes at $73 on option expiration. If this happens, you won’t exercise your 80 calls, because they are out of the money. Your short 75 calls won’t be assigned, because they are out of the money as well. In this case, all of the options expire worthless and no stock is bought or sold. However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices below $75.

As you can see from these scenarios, using credit call spreads works to your advantage when you expect the price of XYZ to fall, which would result in a narrowing of the spread price or, ideally, both options expiring worthless.
Before you consider the sale of uncovered calls or puts, consider the amount of risk you may be taking and how that risk could be significantly reduced through the use of credit spreads.

Advantages and disadvantages of spreads

To summarize, credit put and credit call spreads have both advantages and disadvantages compared to selling uncovered options.

Advantages of credit spreads

  • Spreads can lower your risk substantially if the stock moves dramatically against you.
  • The margin requirement for credit spreads is substantially lower than for uncovered options.
  • It is not possible to lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.
  • Debit and credit spreads may require less monitoring than some other types of strategies because once established, they’re usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warranted—for example, if the underlying instrument moves far enough and quickly enough, you may be able to close out the spread position at a net profit prior to expiration.
  • Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders are able to find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.

Disadvantages of credits spreads:

  • Your profit potential will be reduced by the amount spent on the long option leg of the spread.
  • Because a spread requires two options, the commission costs to establish and/or close out a credit spread will be higher than the commissions for a single uncovered position.

Stock Options Trading and Mentoring – Options strategies from pit vet Dan Passarelli

Posted on Thursday, February 27, 2020 at 4:55 PM

For a few decades the first thing I have done each morning after turning on the coffeemaker is to check the movement in futures markets. I follow the financial and energy sectors closely. My checklist includes stock indexes, interest rates, precious metals, crude oil and currencies. If these sectors have unusually large ranges, I immediately check news stories from around the globe to see what catalyst stirred the markets. I learned to do this very early in my career. Being already technically sound in my approach, this habit taught me how to react when the fundamentals changed.

The coronavirus has spread exponentially, and we have learned a lot from the extraordinary moves in many markets. Stocks have taken a huge hit because of the probable disruption in supply chains. Oil has gone down dramatically because of a likely interruption in travel, which causes demand to decrease while supply increases. Gold prices have risen quickly, and so have bonds and notes. These markets are commonly thought of as safe havens in times of chaos and conflict. The Japanese yen dropped at first but recovered quickly. It tends to rally when gold and bonds do.

By focusing on the correlations between the sectors, we may be able to identify when markets are ready to reverse. If gold, bond and yen prices stabilize, it may be the first sign that bear markets in stocks and oil may be nearing an end.

No one seems to know how deeply this virus will embed itself, though it has spread to all continents. The projections for affected humans and deaths are terrifying. My wife is an infectious control practitioner for a trauma hospital. Obviously, the staff there is taking this virus very seriously. She says there are ways to protect yourself. It is imperative that you wash your hands often. She claims a 20-second cleansing is ideal. Keep a bottle of sanitizer handy, especially when in public areas. Also, refrain from touching your face because that is how the bug enters your body. Be careful and pass this information to family and friends.

Weekly Options Credit Spread

Weekly options credit spread strategy is one of the most popular option trade strategies with weekly options. For those that are new to options, a credit spread is where you sell one option that is closer to the current market price and buy an offsetting option at a farther out of the money price.

The option you sold since it is closer to the current market price it then has a higher premium than the farther out of the money option that you purchased. The difference in premiums between the two options generates a credit in your account that you can keep if the options expire out of the money. If this sounds confusing let look at an example.

Weekly Options Credit Spread Example

Say you were looking at XYZ stock priced at $50. You think that in the near term that the stock is going to move up. You don’t want to tie up a lot of money buying the stock so you could use weekly options to sell an out of the money put.

Sell $48 put for $0.80 credit

Buy $46 put for $0.40 debit.

The difference between the $0.80credit and $0.40 debit is a $0.40 credit (or $40 profit per spread). If the stock closes above the $48 strike price then you keep that entire $40 credit. The risk is if the stock closes below that $48 strike price then you max risk is if the stock closes at of below $46. This would generate a $160 loss per spread.($48-$46 =$200 loss minus the $40 credit you received from selling the spread = $160 max loss)

With weekly options you start seeing almost immediate time decay erosion on the options since ever week is essentially expiration week. Whereas, with tradition monthly options if you wrote a credit spread with four weeks until expiration you might not see much time erosion until the last week assuming the stock hasn’t moved in price much.

Put Credit Spreads

A weekly option put credit spread like above can be used if you are bullish on a stock of if you think the stock will just sit and not move. You could also generate even higher credits the closer to the money that you write a spread. For example using the XYZ stock at $50 list above, if you were really bullish on a stock that had just pulled back you could sell a put credit spread that is in the money by selling $52put and buying a $48put to get an even bigger premium credit.

If the stock doesn’t bounce quick enough for you in the week that you sold the in the money put option you could roll the spread to next week or even have the stock put to you if that was you plan(some investors who like a stock and would be happy owning the stock will sometimes just sell puts if the premium is good ever week until the stock is put to them and then start selling covered calls against that long stock.

Call Credit Spreads

A weekly option call credit spread is used if you are bearish on a stock and think that it won’t move any higher. You would sell a closer to the money call option and buy a higher strike(farther out of the money) call option for a combined premium credit. These can be a little riskier than put option because stock tend to move higher over time and if a short call is exercised against you end you have to deliver the stock or just close it out.

Overall credit spreads are a popular strategy with weekly options as you can keep writing new spreads ever week for continued tiem erosion and if the stock moves against you then you can easily roll the same spread to the next week until the stock pulls back or roll it up to higher strikes. There is a lot more flexibility for an income trader with weekly option income trades because your goal as an income trader is generating rapid time decay.

Weekly Options Credit Spread Risks

Realize though that with the short time to expiration with weeklys that you are usually dealing with closer to the money strike prices in order to generate any decent credit premiums vs. monthly options that sell at higher premiums since they have a longer life. This is important to understand in that you might have to manage weekly options credit spread trades more than you would with monthly options if the stock moves around a lot. Image Wikipedia

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Good Choice For Experienced Traders! 2nd place in the ranking!

Like this post? Please share to your friends:
Guide How To Become Binary Options Trader
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: