What Is the Credit Spread Strategy?

Veteran traders use various trading strategies to improve the risk-return ratio and cost efficiency of their option trades. By learning and practicing these strategies, you can avoid being just a speculator and use hedging to minimise losses.

The credit spread strategy is one such trading strategy that you can use to make consistent profits regardless of market conditions. If you would like to get predetermined gains while taking limited risks in options trading, credit spreads strategies may be suitable for you.

The following sections cover all you need to know about credit spread strategies.

What is the Credit Spread Strategy?

A credit spread is an options trading strategy which involves buying and selling options of the same category with the same underlying security and expiry date but different strike prices. It is implemented in such a way that there is a net inflow of option premiums. This simple to execute nature makes it popular among investors. 

Types of Credit Spread Options

Credit spreads are quite versatile and you can figure out a combination of options to take bullish or bearish positions using them. There primarily two types of credit spread strategies:

1. Credit Put Spread

This strategy is implemented in place of a sale of uncovered put options. It is when the price of an underlying security (stock) or index is expected to rise. Its main aim is to generate income for traders when they sell the uncovered put or wait until its expiration.

It involves the purchase and sale of options in the same category on the same underlying asset. A vertical credit put spread is the buying and selling of two put options having the same expiry date and underlying asset while its strike price would be different.

Example of Credit Put Spread

BSE Sensex is currently trading at 55,668. You can initiate a credit put spread by purchasing out of the money put option at a strike price of 55,520 (Strike 1) for ₹50 and selling at the money put (or in the money) option at a strike of 55,700 (Strike 2) for ₹125.

The net premium inflow is ₹75. 

Breakeven spread = Strike 2 – Net Premium

= 55,700 – 75 = ₹55,625

Maximum Loss = (Strike 2 – Strike 1 – Net Premium) x Lot Size

= (55,700 – 55,520 – 75) x 30

= ₹3,150

Maximum Profit = Lot Size x Net Premium 

= 75 x 30 

= ₹2,250

Case 1 – BSE Sensex Drops, Expiring at 55,300

The short put option at a strike price of 55,700 starts with a loss in premium collected. This loss arising from the short position is covered up with the long put option at 55,520. 

The loss will be:

= Loss (55,700 – 55,300) * 30 + Profit (55,520 – 55,300) * 30 + Premium (75 * 30)  OR

= (Strike Price 2 – Strike Price 1 – Net Premium) x Lot Size

= (55,700 – 55,520 – 75) x 30

= ₹3,150

Case 2 – BSE Sensex Drops Slightly, Expiring at 55,650

The short put option at a strike price of 55,700 will retain ₹50. However, the long put of strike 55,520 will expire without being exercised. The spread can retain a portion of the premium, which is ₹ 750 because 55,650 is slightly above the breakeven point of 55,625. Therefore, there will be a profit of ₹750 when the BSE Sensex expires at 55,650.

Note: Premium Received = (55,650 – 55,625) x 30 = ₹750

Case 3- BSE Sensex Rises Massively, Expiring at ₹55,800

The trader will be able to make a profit from this strategy, but the two options will expire worthless. The maximum profit is the same as the net premium received, which is ₹2,250.

Note: 75 x 30 = ₹2,250 [Net Premium x Lot Size]

2. Credit Call Spread

It is a bearish spread strategy when the underlying security’s price is expected to go down (bearish) throughout the tenure. It involves selling uncovered call options on a particular security where traders expect the underlying security or index to move downward.

It aims to make profits by selling an uncovered call and then waiting until the option expires worthless. When this happens, the premium you receive from selling is always higher than the premium you pay for buying the contract. Therefore, it leads to a positive cash flow or gain.

Example of a Credit call Spread

BSE Sensex is trading at 55,500. You can initiate a credit call spread by selling an At the money call option at a strike price of 55,520 (Strike 1) for ₹130 and purchasing an Out Of the money call option at a strike of 55,700 (Strike 2) for ₹50. These options have the same expiry date.

The net premium inflow is ₹80. 

Breakeven Spread = Strike 1 + Net Premium

      = 55,520 + 80 = 55,600

Maximum Loss = (Strike 2 – Strike 1 – Net Premium) x Lot Size

= (55,700 – 55,520 – 80) x 30

=₹3,000

Maximum Profit = Net Premium Received x Lot Size

= 80 x 30 

= ₹2,400

Case 1 – BSE Sensex Call Expires at 55,000

This long call option expires at 55,700, which leads to forsaking the premium money paid. The short call also expires without being exercised, but because of short option trade, retaining a credit equals the premium of ₹2,400.

Case 2 – BSE Sensex Call Expires at 55,580

This short call position at 55,520 strike price retains ₹60. However, the long call option of 55,700 strike price will expire worthless. Because 55,580 is below the breakeven point (which is at 55,600), the spread can provide a maximum premium of ₹20 (55,600-55,580) i.e., profit of ₹600 (20*30) .

Case 3 – BSE Sensex Call Expires at 55,700

This short call position at 55,520 starts to ruin the spread, though the long position at 55,700 provides a safe zone against the loss. 

Loss = (strike price 1 – strike price 2 – net premium) * lot size

= (55,520 – 55,700 – 80) * 30 = ₹3,000 Pro of Credit Spread Strategies

• These spreads can lower your risk whenever the stock moves against you.
• In comparison with an uncovered option, the margin requirement is lower.
• Less regular monitoring is required than other strategies because once a credit spread is established, it is held till expiration.
• Losses are limited as it is the difference between the strike price of the two contracts.
• Spreads are considered as versatile with various strike prices and expiration dates. Usually, the traders figure out a combination of contracts that will allow them to take a bullish or bearish move on a particular stock.

Cons of Credit Spread Strategies

• Your profit potential gets reduced due to the spread which lowers your risks.
• The involvement of two options makes it more expensive compared to a single uncovered position. Therefore, traders should be mindful of the higher fees.

Final Words

The simplicity of credit spreads makes it easy for even a new trader to implement them in any market condition, regardless of the underlying asset’s price fluctuations. Moreover, the quantum of gains and losses can be pre-determined and limited. It mainly aims to retain the premium received, which typically results in regular profits. 

Frequently Asked Questions