Credit Spread (Options)
Credit spread is also known as net credit spread. A credit spread occurs when two options of the same class are simultaneously bought and sold. These two options are also required to have same expiration date, though they have dissimilar strike price. The customer obtains net credit for creating this position. The ultimate purpose behind the creation of this position is to expect the spreads to expire to profit or for the spread to be narrowed down. A credit spread is opposite to debit spread where the investor is required to pay for creating the position.
There are several ways in which a credit spread position may be designed. An investor may choose to go for a vertical spread where options of the same stock or index are bought and sold simultaneously. These two options are required to belong to different strike price class. If the investor is bearish in outlook then a credit spread with bearish outlook is created. E.g. Trader X expects security ABC’s price to fall from its S40 price level. The trader buys 10 calls of the strike price $43 at $.50 each and he also sells 10 $42 calls at $.90 each. The trader’s total layout is $500 while he receives $900 from writing the options. The net credit of $400 accrues to the dealer. If the stock price remains below $42 by the expiry day then both the options will expire worthless and the trader will get to keep the net margin obtained at the creation of the spread. The trader will, however, be required to pay commissions and taxes.
However, if stock price goes above $43, then the trader would be required to unwind the position and would need to buy $42 call back and sell $43 call. Since the difference in strike price is $1, the total outlay would be $1000 for 10 calls and the net loss for the trader would be $1000-$400 i.e. $600. The third scenario entails the final price between $42 and $43. In such a case, both your loss and gain will be minimized, depending on the actual price of the stock. Overbought shares are considered to be the best bet for bearish credit spread position. Traders use technical indicators for determining such stocks.
Similarly, an investor may opt to create a bullish credit spread if he feels that the security price is likely to run up in the near future. E.g: Stock ABC is currently trading at $25 and the trader expects the stock to jump sharply. In such a case, the trader may choose to write 10 lots of $24 put at 0.60, netting $600. At the very same time, the trader may also buy 10 lots of $23 puts at $0.35. The net credit of $250 will accrue to the trader. If the stock price remains at $25 or rises in that case both the put options will expire worthless and the trader would keep to retain the initial income of $250, minus commissions and brokerage.
Alternatively, the stock price may fall below $23, in such as case the trader would need to unwind both the positions and the total cost would be $1000 for this purpose. The trader in this case would suffer a loss of $750, the difference between his initial credit income and subsequent total loss. If the stock remains between $23 and $24, then the trader’s loss or profit would minimize and the total quantum would depend on the actual price of the stock at the time of expiry. Traders prefer to pick oversold stocks for the purpose of bullish credit spread. Several technical indicators are used for the purpose of identifying such oversold stock.
Credit spread provides the opportunity to earn modest income with the risk of limited loss. The strategy is generally employed for the purpose of generating small income with moderate risk. However, the trader remains to be aware of the risk involved.
The credit spread strategy also has a breakeven point. For the purpose of determining breakeven point, the net premium obtained in the beginning is added to the lower strike price of the call. In case of put option strategy, the net premium less higher strike price gives the breakeven point. Similarly, the maximum profit you can derive from credit spread strategy is determined by calculating net credit or the difference in premiums. The maximum loss sustained from the strategy equals the difference between strike prices less net credit.
Credit spreads tend to benefit from lower volatility and the trader gains when the price of the stock does not change. In this way, such credit spread strategy has low vega. This strategy also has positive theta since generally if the price of the stock does not move, the time depreciation goes in favor of the trader.