Languages : English | Bahasa Indonesia
Home | Define | Videos | Answers | Quiz | Download | Further Reading | Beginner Course | About | Contact
|Home > Advanced Options Trading > Options Spreads > Credit Spreads|
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.
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!)
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.
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.
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.
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.
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?