What is a Credit Spread?

A credit spread is an options strategy that caps potential profits at a defined limit in return for a higher probability of profit and a strictly defined max loss. Assembly entails buying and selling options of the same class — with the same expiry.

The strategy is executed by selling a (more expensive) option with a strike price closer to the price of the underlying asset and buying another (less expensive) option with a strike price further from the price of the underlying asset.

Credit spreads collect bigger premiums when IV is elevated. This allows for strike selection further OTM — increasing the zone of profitability.

Employing credit spreads when IV is high reduces risk and increases your probability of profit.

Vertical Credit Spread Variations

1. Call Credit Spread (aka bear call spread -or- short call spread)📉

2. Put Credit Spread (aka bull put spread -or- short put spread)📈

Call credit spreads are neutral/bearish, while put credit spreads are neutral/bullish.

A call credit spread is a sensible strategy for a trader that holds a neutral to bearish outlook, whereas a put credit spread would be of use for a trader that expects neutral to bullish price action.

Strategy Construction 🏗

Call Credit Spread:

• Opening a call credit spread entails selling a call with a lower strike price and buying a call with a higher strike price.

Put Credit Spread:

• Opening a put credit spread entails selling a put with a higher strike price and buying a put with a lower strike price.

In both cases, the premium collected for the short position exceeds the premium paid for the long position. The result at the outset of the trade is a net credit.

Max profit for a credit spread is limited to the initial credit received. Max loss is limited to the difference between the two strike prices less the initial credit received.

Call Credit Spread Payoff Function

Max Profit:

• Spot price is at or below the strike price of the short (lower strike) call at expiry

Max Loss:

• Spot price is at or above the strike price of the long (higher strike) call at expiry

Breakeven:

• Short (lower strike) call strike price plus net credit received

Call Credit Spread Example

SOL is trading at $33, and you feel bearish in your bones.

You sell 1000 $36 calls for $1.50 per contract and buy 1000 $38 calls for $0.70 per contract.

1000 x $1.50= $1,500 (credit)

-

1000 x $0.70 = $700 (debit)

=

$800 (net credit)

Max Profit:

• $800 initial credit, realized if SOL is trading at or below $36 at expiry

Max Loss:

• $1,200 ($2,000 - $800), realized if SOL is trading at or above $38 at expiry

Breakeven:

• $36.80 ($36 + $0.80)

Put Credit Spread Payoff Function

Max Profit:

• Spot price is at or above the strike price of the short (higher strike) put at expiry

Max Loss:

• Spot price is at or above the strike price of the long (lower strike) put at expiry

Breakeven:

• Short (higher strike) put strike price minus net premium received

Put Credit Spread Example

SOL is trading at $33 and you're feeling bullish.

You sell 1000 $32 puts for $1.90 per contract and buy 1000 $28 puts for $0.70 per contract.

1000 x $1.90 = $1,900

-

1000 x $0.70 = $700

=

$1,200 (net credit)

Max Profit:

• $1,200 initial credit, realized if SOL is trading at or above $32 at expiry

Max Loss:

• $2,800 ($4,000 - $1,200), realized if SOL is trading at or below $28 at expiry.

Breakeven:

• $30.80 ($32 - $1.20)

Conclusion

Credit spreads are a valuable and efficient options strategy for traders seeking to generate income and manage risk in various market conditions. By selling higher premium options and simultaneously buying lower premium options, traders can collect the net credit while limiting their potential losses.

Credit spreads are well-suited for those with a neutral to mildly bullish or bearish market outlook, as the strategy benefits from time decay and decreasing implied volatility. The flexibility to create call credit spreads or put credit spreads allows traders to cater the strategy to their specific market expectations and risk appetite. As with any trading approach, it is essential to thoroughly understand the mechanics, risks, and potential rewards of credit spreads to effectively utilize them in your trading arsenal.