Credit Spreads

Learn about what Credit Spreads are in options trading and its advantages and limitations.

Credit Spreads - Definition

Credit Spreads are options positions created by buying cheaper options contracts and simultaneously writing more expensive options contracts.

Credit Spreads - Introduction

How about being a "banker" in options trading?

Well, that's what credit spreads are designed to do in options trading.

Credit Spread is one of the two kinds of options spreads, the other being the Debit Spread. Credit spreads truly gave options trading some of its wonderous effects such as allowing you to profit even when the price of the underlying stock is sideways. Indeed, the ability to profit in neutral markets made credit spreads the most popularly taught options spreads by options gurus worldwide. However, despite the popularity, credit spreads are a lot more complex than its debit spread cousins and also require a higher trading account level as well as margin.

This tutorial shall explore in depth what Credit spreads are, how they work and briefly introduce the different kinds Credit spread options strategies.

What are Credit Spreads?

Credit spreads refers to options spreads that you actually receive cash (net credit) for executing them. This credit to your options trading account is why such options spreads are known as "Credit Spreads".

When you write an option, you are putting on a short options position but when you buy a cheaper option on the same underlying stock using the premium received from the sale of the short options position, a Credit Spread is created.

This means that the short legs in a Credit spread generate more than enough premium to offset the price of the long legs with cash premium remaining to be received. Options spreads that does the opposite of debiting your account (reducing your cash balance) instead are known as "Debit Spreads". This means that you actually receive cash for putting on a Credit spread while you will pay cash for putting on a debit spread.

An example of a credit spread is the Bull Put Spread which consists of buying cheaper out of the money put options and then writing more expensive in the money or at the money put options resulting in cash received from the transaction right from the start.

Credit Spread Example Assuming QQQ is trading at $61, its Mar $61 put options are trading at $0.60 and its Mar $60 puts are trading at $0.20. You are expecting QQQ to remain stagnant or to go upwards. Instead of writing only the Mar $61 put options (which makes a naked put write), you decide to go for a bull put spread by buying also the Mar $60 Put options in order to lower margin requirements and to prevent further losses should QQQ fall below $60. Bull Put Spread = $0.60 - $0.20 = $0.40 Credit into your account

You must know the difference between credit spreads and debit spreads before you can consider trading options spreads due to the fact that each type carries with it unique characteristics that significantly affect your options account and risk appetite.

Purposes of Credit Spreads

So why do options traders and even market makers trade Credit spreads? What is the purpose of Credit spreads in options trading?

Credit spreads were created primarily for reducing margin requirement of naked write options positions and to put a limit to an otherwise unlimited loss potential. Naked write is when you sell options without a corresponding position in the underlying stock or a long position in an opposite options position as collateral. This results in naked writes requiring very high margin to put on even though you still do get cash credit from putting on the position. By writing a credit spread, you will be able to lower the margin requirement of the position significantly as the cheaper long legs act as partial collateral. This is particularly useful when you expect the underlying stock to remain relatively stagnant or move only moderately (Learn about the Six Main Outlooks in Options Trading).

Even though buying a cheaper option against a naked write position lowers the profitability as part of the premium received from the sale of options would go towards buying the cheaper option, the significantly lower margin and limited risk that results makes credit spreads more worthwile and safer than naked write positions.

Credit spreads typically comes with limited profit potential and limited risk potential; this means that there is usually a ceiling on the maximum achievable profit (usually the net credit received) and a floor to the maximum possible loss, making the reward risk ratio of the options position predeterminable. Due to short options' ability to profit from time decay with the underlying stock remaining relatively stagnant, credit spreads are usually famous for being neutral options strategies even though credit spread volatile options strategies (such as the short butterfly spread and short condor spread) as well as credit spread bullish and bearish options strategies do exist as well. Due to time decay being a friend of credit spreads, credit spreads are also capable of profiting in more than one direction; usually when the price of the underlying stock remaining stagnant as well as in a single direction or even in all 3 directions, thereby greatly increasing the probability of profit of credit spreads. For instance, a bull put spread would be capable of profiting when the price of the underlying stock goes up, remain stagnant or even drop slightly (Yes, all 3 directions!)

Credit Spread Profit & Loss Limit Example Assuming you wrote the QQQ Mar 61/62 Bull Put Spread in the preceding example. The at the money Mar $61 Put will expire worthless allowing you to pocket its full premium of $0.60 as long as QQQ remains above $61. If the price of QQQ should drop below $60, the Mar $60 Put would rise dollar for dollar with the Mar $61 Put, offsetting any further losses. Bull Put Spread maximum profit = $0.60 - $0.20 = $0.40 Maximum loss = ($62 - $61) - $0.40 = $0.60 The reward risk ratio in this case would be: Reward Risk Ratio = $0.40 / $0.60 = 0.67

Types of Credit Spreads

There are Credit spreads for every class of options strategies; Bullish, Bearish, Neutral as well as Volatile and are typically limited risk and limited profit. Here are links to such limited risk limited profit options strategies where you can find plenty of credit spreads.

Bullish Limited Risk Limited Profit

Bearish Limited Risk Limited Profit

Neutral Limited Risk Limited Profit

Volatile Limited Risk Limited Profit

The most common bullish Credit spread is the Bull Put Spread, the most common bearish Credit spread is the Bear Call Spread, the most common neutral Credit spread is the Iron Butterfly Spread and the most common volatile Credit spread is the Short Butterfly Spread.

How Do Credit Spreads Work?

So, how do Credit spreads work the way they do in options trading? What is the underlying principle behind Credit spreads that allows them to lower margin requirements, profit in more than one direction and limit risk?

All Credit spreads consist of being short near the money options while simultaneously being long on out of the money options. The extrinsic value of the out of the money option takes up part of the premium received from the sale of near the money options and act as partial collateral that reduces margin requirement due to the limited risk.

How Credit Spread Work Example 1 Assuming QQQ is trading at $61, its Mar $61 put options are trading at $0.60 and its Mar $60 puts are trading at $0.20. You write one contract of the Mar $61 put options for $0.60 and buys one contract of the Mar $60 put options for $0.20. Net Credit = $0.60 - $0.20 = $0.40 In this example, the premium received reduced from $0.60 to $0.40 (33% lower) due to the purchase of the Mar $60 put options but the Mar $60 put options will rise dollar for dollar with the Mar $61 put options if QQQ drops below $60, thereby eliminating any further losses below $60.

In a credit spread, even though maximum loss is limited due to the strike price of the long legs, the maximum loss potential would usually be higher than the maximum profit potential and there is always the risk that such a loss would not be covered by the credit spread trader and that is why margin would be required for credit spreads even though the margin required would be much lower than writing the put options without the long leg.

How Credit Spread Work Example 2 Following up on the above example... Assume instead of rallying, QQQ unexpectedly drops to $59 by March expiration. The short Mar $61 put options rallies to ($61 - $59) = $2 from $0.60 resulting in a loss of $1.40. The long Mar $60 put options rallies to ($60 - $59) = $1 from $0.20 resulting in a gain of $0.80. If you have simply wrote the Mar $61 put as a naked put write, you would have lost $1.40. However, the credit spread in this case resulted in a total loss of only $1.40 - $0.80 = $0.60.

In a credit spread, maximum profit potential is limited due to the fact that the source of profit is usually the extrinsic value received from writing the short legs. As such, the maximum possible profit of a credit spread can be predetermined through mathematical formula and considered for options trade planning before actually executing the trade.

How Credit Spread Work Example 3 Following up on the above example... Assuming QQQ rallies to $63 by expiration. The March $61 put expires out of the money, allowing you to pocket the whole premium of $0.60 as profit. The March $60 put also expires out of the money, losing the amount of $0.20 paid towards buying them. As you can see above, the maximum profit of the position can only be $0.60 - $0.20 = $0.40 no matter how high QQQ rallies to. This is why credit spreads are usually used when the price of the underlying stock is expected to remain stagnant or rally moderately.

However, it is also due to the fact that the source of profit for a credit spread is the premium received from writing the short legs, credit spreads are usually capable of profiting in more than one direction.

How Credit Spread Work Example 3 Following up on the above example... Assuming QQQ remains at $61 by expiration. The March $61 put expires out of the money, allowing you to pocket the whole premium of $0.60 as profit. The March $60 put also expires out of the money, losing the amount of $0.20 paid towards buying them. As you can see above, the credit spread continues to make the full profit of $0.60 - $0.20 = $0.40 even if QQQ remain stagnant. Yes, credit spreads are usually multi-directional strategies.

Calculating Return on Investment (ROI) of Credit Spreads

Return on investment tells you how profitable your investment is and is simply calculated by dividing profit against capital committed. If you commit $10,000 to an investment and that investment returns $5000 as profit, its ROI is 50% ($5000/$10,000 = 0.5 x 100 = 50%). Return on investment is extremely easy to determine for debit spreads since you actually pay money to buy such a position. So, how can return on investment be calculated for credit spreads which not only requires no money to put on but instead credits your account with cash right from the start?

Even though you do not need to pay cash in order to put on credit spreads, a significant amount of cash known as the "margin" will be required to be held in your account in order to put on a credit spread in the first place. This margin amount cannot be used for any other purposes and is reserved exclusively as collateral for the credit spread. As such, the margin amount becomes the investment you make into a credit spread trade and should become the basis for calculation of ROI.

Credit Spread ROI Calculation Example Following up on the above example... You bought 1 contract of the March $60 Put and wrote 1 contract of the March $61 Put and $200 is held in your account as margin requirement. Assuming QQQ rallies to $63 by expiration. The March $61 put expires out of the money, allowing you to pocket the whole premium of $0.60 x 100 = $60 as profit. The March $60 put also expires out of the money, losing the amount of $0.20 x $100 = $20 paid towards buying them. Total profit = $60 - $20 = $40 Return on Investment (ROI) = Profit / margin = $40 / $200 = 0.2 = 20%

In the example above, for holding up $200 in your account as margin for the execution of this Bull Put Spread, you made a $40 profit. Since that profit came from holding up $200 in your account, the $200 should be regarded as being committed or invested into the Bull Put Spread and should become the basis for calculation of ROI, which in this case works out to be 20% ROI.

Account Level Required for Credit Spreads

Because credit spreads require margin and carry a higher risk in terms of reward risk ratio as well as risk of default in case of assignment, it would require a higher account trading level than debit spreads. However, due to the limited risk potential, credit spread also requires a lower account trading level than naked write positions. As such, credit spreads typically require options account trading level 4. Read more about Options Account Trading Levels.

Advantages of Credit Spreads

:: Cash received upfront
:: Capable of profiting in more than one direction
:: Limited loss potential
:: Lower margin requirement than naked write positions

Disadvantages of Credit Spreads

:: Margin is required
:: Higher account level needed than debit spreads
:: Usually has disfavorable reward risk ratio

Credit Spread Questions

:: How Does Time Decay Work in Credit Spreads?