The Credit Spread

Of all the advanced options techniques, the credit spread is a natural addition for the conservative option seller to consider learning. Like cash-secured put selling, entering into a credit spread provides an immediate infusion of cash into your account, which again you hope to convert to income as the time value of the spread you enter wastes away. Because it is done on margin, and because your loss is capped, you can consider entering into larger positions than with cash-secured put selling.

Let’s look at the credit spread. It can be constructed using puts or calls. It involves the sale of one option and the purchase of another at a further-away strike price but of the same expiration date. It always results in the investor receiving a net credit, equal to the difference in premiums for the two options, into her account. With the passage of time the price differential between the two options narrows. The investor has the goal of both options expiring worthless, and the full credit retained as income.

Credit spreads constructed using puts are sometimes called bull-put spreads, because the position is entered when the investor believes the underlying will increase in value, causing the put spread to waste away to zero with the passage of time. Likewise, call credit spreads are sometimes termed bear-call spreads, because they provide the maximum credit when the underlying decreases in value.

The maximum gain an investor can make is the full value of the credit received. As always with options, there is risk involved. Because the bought option will increase in value if the market moves adversely, the downside on spreads is limited. The maximum loss on any credit spread is the difference between the strike prices of the two options minus the net credit received. Because of this built-in down side protection, many option seller prefer to use this technique to all others.

I really like credit spreads and use them often. I especially like entering credit spreads with only a week or two left in the options life.

For further information about credit spreads refer to the Ongoing Education section of this site.