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Published On: Sat, Jan 19th, 2013

Credit spreads explained

Anyone who goes on an introductory course in options trading will no doubt become familiar
with credit spreads. This remains one of the most popular trading strategies among traders of
all levels for a variety of reasons.

Definition

A credit spread is an options trading spread for which the trader does not have to pay an
upfront fee. Instead the trader is actually paid to set up a credit spread! The reason for this is
that credit spreads involve selling more expensive options and buying cheaper ones, which
means the net premium results in a credit to the trader’s account.

Margin and trading Level

There is a trade-off though: whereas a debit spread does not involve any margin, since
the trade can usually not lose more than the net cost to set up the position, a credit spread
sometimes has the potential to lose an unlimited amount of money. This results in brokers
requiring a margin deposit before a trader can set up a debit spread. For stock options a
higher trading level is usually also required than for debit spreads.

Benefits of credit spreads

Whereas most debit spreads require the price of the underlying asset to move either up
or down in order to profit, credit spreads have the unique ability to profit if the price of the
underlying asset remains stagnant or moves in a narrow range.

Although some credit spreads have unlimited potential for loss, there are also many other
credit spreads with a limited potential for loss.

While credit spreads require a margin deposit, they still require a smaller margin deposit than
naked puts or naked calls. In fact the lower margin involved is one of the reasons why many
traders prefer credit spreads over selling naked options.

Although most credit spreads will profit in a stagnant or range-trading market, there are also
credit spreads that will profit if the market breaks out either to the upside or the downside.

Examples:

A credit spread for bullish markets

Below is an example of a typical bullish credit spread, the bull put spread. This involves
selling ATM put options and simultaneously buying OTM put options for the same expiration
date.


Fig. 9.28(a)

A credit spread for bearish markets

Below is an example of a credit spread for a bearish market. The bear call is set up by selling
ATM call options and simultaneously buying the same number of OTM call options for the
same expiration date.


Fig. 9.28(b)

A credit spread for neutral markets

If a trader believes the market will remain either stagnant or range-bound until the expiration
date he or she can’t do much better than a credit spread specifically intended for neutral
markets. One such example is the very popular iron condor, which consists of selling OTM
calls and OTM puts while simultaneously buying further OTM calls and puts which are
cheaper.

Fig. 9.28(d) is an example of a typical iron condor credit spread.


Fig. 9.28(d)

A credit spread for volatile markets

If it is highly likely that the price of the underlying asset will break out either to the upside or
the downside, a trader should opt for a credit spread designed specifically to benefit from this
situation. An example in this regard is the ever popular short butterfly spread that is illustrated
below in Fig. 9.28(e).


Fig. 9.28(e)

This trade is set up by buying two ATM call options and simultaneously selling an OTM call
and an ITM call. The higher premium income from the ITM call helps to more than offset the
cost of the ATM calls, creating a net credit.

Conclusion

While credit spreads can be ideal under certain circumstances, one always has to take into
account a) the probability of the trade actually realising a profit and b) whether the maximum
risk/maximum profit payoff justifies the trade.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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