Credit Spreads Explained



Credit spreads are one of the many investment strategies that you can choose to use. In this strategy you will receive a greater premium for the short leg of the spread, than the premium paid for the long leg. This means that you will receive a net credit in your account.

The amount that you will receive in your account will be the maximum profit you can achieve using this trading strategy.

You can use credit spreads in a bearish or bullish market. Now we will take a look at each market by looking at some examples.

Bullish Credit Spread

If you think that the future fore an underlying security is bullish then you can place a bull put credit spread.

For example, if IBM was currently trading with a value of 150, and you think that the immediate future for the company is poor. Then you can place an IBM APR 120/115 put credit spread. This would help you see a net credit of $0.40 per option.

This is constructed with the following credit spread options:

Sell – IBM APR 120 PUT (APR)

Buy – IBM APR 115 PUT (APR)

Bull Credit Spread

Reserve Requirements

Anyone who decides to execute credit spread positions will need to ensure they maintain a certain amount of money in their trading account. This is detailed in the option contract and it is a way to secure your obligations if the options are ever exercised.

The actual amount of money that you are required to keep in your trading account will vary depending on the broker you are trading with. Normally though they expect around 12% of the price of the options available in your account.

Calculating Cash Requirements

To work out your cash requirement subtract the Net Credit from the Option Strike difference and multiply by 100. In the example with IBM above, the cash requirements are $5-$0.40 x 100 = $460 per option contract.

Maximum Profit

You can also calculate the maximum profit that you can potentially make from executing the put order. When the IBM trade is executed, you will receive the $0.40 net profit immediately into your account. In this example the net credit is $0.40 x 100 = $40.

Maximum Loss

Of course, with any investment it is also possible that you lose money. If IBM stocks move in the wrong direction, then you could lose money. In order to prevent this affecting you, you could place a contingent trade. This would help to close the open position.

This will help to limit the maximum amount of money that you can lose. To work out the maximum potential loss, it is the net credit subtracted from the option strike difference multiplied by 100. In this case the maximum potential loss would be $460 per option contract.

Bearish Credit Spread

If you are bearish on the security, then you can also maintain a net credit by purchasing a bear call credit spread.

If IBM stocks are currently at 150 and you think that this is highly overvalued, then you can choose to execute an IBM APR 200/205 call credit spread. This will help you to receive a net credit of $0.40 per option.

This is made up of:

Sell – IBM APR 200 Call

Buy – IBM APR 205 Call

Reserve Requirements

As with the previous example, the broker will require you to keep a certain amount of cash in your account to cover your obligations. The actual requirements will vary depending on the broker.

In the example above, the cash requirements are: ($5 – $0.40) x 100 = $460.00 per option.

Maximum Profit

If you do execute the trade then you will receive the $0.40 per option as net profit back into your trading account. In the example above the net profit would be $0.40 x 100 = $40.00.

Maximum Loss

If IBM moves in the opposite direction to you expect, then you could lose money. To limit your losses you can place a contingent trade.

The Maximum Potential Loss = (Option Strike Difference – Net Credit) x 100

In this example, the maximum amount that you can lose is $960.00. This is calculated by ($10 – $0.40) x 100 = $960.00.

Conclusion

You might want to use credit spreads because they are a bit less risky than using naked puts. However, they are only less risky if you also utilize contingent trading strategies. If you don’t do this then your potential losses are much larger.

As trading credit spreads is very confusing, it’s important that you get advice before you start. You could use a virtual trading account to teach yourself more about this.

You can get virtual accounts with many brokers, including optionsXpress. This broker also offers excellent guides about how to set up credit spreads and make sure your trades are profitable.

 




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