Options Strategies Made Easy: Credit Spreads

So perhaps you’re wondering – what in the world is a credit spread?
Well, a credit spread is very simply a safe means of collecting premium –  i.e., generating a credit – in either up or down markets.
By “safe” I don’t mean to imply that you can’t lose on the trade. Rather, credit spreads offer an opportunity to know your precise risk and reward in advance, as well as a chance to tailor the initiative to fit your personal risk profile.
More on that in a moment.  But first…

How Does a Credit Spread Work?

Credit spreads involve the simultaneous sale and purchase of two options – either two calls or two puts – with the same expiry but different strike prices. The difference between the sold (expensive) option and the purchased (cheaper) option is your net credit for the trade.
Let’s look at some real-life examples to understand the strategy better.

1. Selling a ‘Put Spread’ When Bullish

Let’s consider a bullish scenario. Let’s say Apple (NASDAQ:AAPL) stock has been moving nicely of late, and you foresee the rise continuing.

You note that the stock has just broken to new highs, and there appears to be good support in the $96 range, so you figure that’s a good level at which to base your credit spread.

• You therefore sell a put at that level – the December 96 strike, and bring in $2.25.
• In order to minimize your loss, however, you also buy a put that’s further out of the money – say, the December 92 strike for $0.68.
• All told, your credit on the trade is $1.57 ($2.25 – $0.68).

And if Apple closes above the short put strike of 96 at expiry, the spread expires worthless and the premium is yours.  The risk, of course, arises if Apple closes below the short put strike at 96.
In that scenario, the calculations are as follows:
Your break-even for the trade is simply the short strike less the initial premium collected. In this case, $94.43 ($96 – $1.57).
And your maximum loss for the trade is the difference between the two strikes times 100, less the initial premium collected, or $243 ($4 x 100 – $157).

2. Selling a ‘Call Spread’ When Bearish

But what if you’re bearish? Then everything works in precisely the opposite direction.
Let’s say Apple stock has had a tough time punching above resistance at $133, the market has been weak overall, and you believe the next move for the stock is lower.

Mirroring the example above, you would simply set up your short call at resistance (133), pulling in $1.40 on the sale, and buy the 135 call for the long leg of the trade. If the latter cost you $0.55, your net credit would be $0.85 per spread, all of which you would collect if Apple remained below 133 at expiry.
Break-even in this case would be $133.85 (short call plus original premium), and the worst-case scenario loss would be $115 (long call less short call times 100, minus original premium).
Note: widening the spread between the options increases both your potential profit and loss.
Best of luck!

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