Anatomy of a Credit Spread

How credit spreads work

Retirement Day Trader is proudly presented by TradingGods.net. Our main strategy is placing vertical credit spreads designed to generate consistent returns with a known amount of risk and reward.

Here's the basic anatomy of a credit spread, along with a rationale for why we trade them and how they can set us up for success.

Definitions

A credit spread is a contract that includes the purchase of one option and the sale of a second similar option with a different strike price. (A strike price is a specified price at which an options contract can be bought or sold when it is exercised).

Credit spreads involve simultaneously buying and selling options that have:

  • Same class
  • Same expiration
  • Different strike price

When you buy and sell options with different strike prices at the same time, you establish a spread position. If the option sold is more expensive than the option bought, you receive a net credit known as a vertical credit spread. If the spread narrows and the option expires "out of the money," you will profit from the strategy.

Vertical Credit Spread

Credit spreads come in the form of calls and puts, which allow you to establish long and short credit positions. The trade can be set up as either a vertical call spread or vertical put spread.

A vertical call spread (bearish call) is used when you have a bearish outlook on the market. A vertical put spread (bullish put) is used when you have a bullish outlook on the market.

Since the vast majority (75-80%) of options expire worthless, vertical call spreads offer limited risk, and a high probability of success. The trade-off is that profit potential is also limited (the maximum profit you can earn is the net premium between the two options).

To set up a vertical put spread, a trader must:

  • Monitor market conditions
  • Open position by selling for a net credit
  • Let expire for profit (best case)
  • Close to limit loss or for partial profit

Advantages of Vertical Call Credit Spreads

Vertical call credit spreads have the following advantages:

  • Reduce the net risk on any trade
  • Ideal if you believe the underlying security will go in your direction, sideways or even somewhat against you between the trade date and expiration date
  • Generate consist returns that can be quantified before the trade is placed
  • Much less risky than shorting stocks
  • Worst case risk is known before you enter the trade
  • You can sell options for credit and seek income opportunities throughout the week
  • You can trade in some of the world's most liquid markets (SPX, NDX, VIX, RUT)
  • By selling options, you become the "house" or "insurance company," not the chump on the losing side of the trade.

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