Options Trading Strategy # 1 – Credit Spreads

If you’re new to Options trading, you may scratch your head with the term “credit spread”. It seems daunting to hear such a technical jargon, but once you get to know what it is, it is very simple. It’s one of the great options trading strategies that you can use on a bear or bull market. Let’s start with defining some of the terms.

What is A Credit Spread?

A credit spread involves buying and selling of options of the same type (either a Call or a Put) but at different strike prices and profiting from the difference in the buy price and the sell price of the options contracts. This options trading strategy works on the fact that different strike prices for options contracts have different premiums associated to it. In the case of a credit spread, you will receive a credit, as you will be buying the lower priced option and selling the higher priced option of the 2 strike prices.

For Example:

Company XYZ – Put Option for $1.00 = 0.30, Put Option for $1.50 = 0.15

In the scenario above, you will buy the $1.50 Put @0.15 and sell the $1.00 @0.30, and this gives you a profit of 0.15 (multiplied by the number of contracts). When you enter into a credit spread, you will automatically get the money for the rate differential, but this is assuming the stock performs well and goes up. This options trading strategy is called the Bull Put Spread. When the stock price for Company XYZ goes up in value, the put options will reduce in value. Thus, if by the expiry date it is well and truly above the $1.50 price, then you get to keep the 0.15 premium you received at the start of the trade. If it doesn’t turn out to be above $1.50, then you will need to buy back the spread and settle your loss by paying the difference in the current spread and the premium of 0.15 you have received.

Bull Put Spread vs Bear Call Spread

As the names would suggest, a Bull Put spread is used when you view that the stock is likely to go above the strike price that you want to enter. The Bull Put spread involves buying and selling of put options at different strike prices, and is the credit spread strategy for a rising stock price. A Bear Call Spread, on the other hand, is used when you view the stock to go below the determined strike price that you want to enter. This is the bearish strategy for credit spreads, and involves buying and selling of calls at different strike prices.

Determining Strike Prices

Credit spread as an options trading strategy can require some skills in determining at what level and expiry date to enter. Knowing what strike price to go for depends on the technical analysis of the stock, and the amount of premium you receive from the credit spread. Obviously you would want to make it worth your while risking the money in the markets, so you have to ensure that you get a decent amount on the premium for the spread. However, having said that, you need to look at the charts to know at which level the stock is likely to reach on a certain date, generally the expiry date of the options contracts that you will be using. It is not as simple as picking the one with the highest premiums.

Knowing Your Risk

With credit spreads, the risk you take on is basically the difference in the strike prices of the buy option and the sell option, times the number of contracts. The spread will never cost you more than the difference in the strike price of the bought option and the sold option. Make sure you are prepared to take that risk, should the market not go to your favour.