What Are Credit Spreads?
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Put Credit | Call Credit
Credit Spreads
Learn how to set up and profit from Credit Spreads
Option spreads, along with calls and puts, are the building blocks to almost all option trading strategies.
An options spread is an options strategy involving the purchase AND sale of an option at different strike prices OR different expiration dates.
All options spread are set up as the same type. They are either all call options or all put options and on the same underlying asset
They differ in only the expiration date or the strike price.
They are set up with the same number of buy options as sell options. If you buy 5 call options, you will also sell 5 call options.
A bullish long call diagonal spread is set up by
- vertical spreads
- horizontal spreads
- diagonal spreads
Vertical spreads are options that differ only in terms of strike price. They will have the same expiration and are of the same type ( all calls or all puts )
- call spreads
- put spreads
- —————-
- bull spreads
- bear spreads
- —————-
- credit spreads
- debit spreads
Option Basics
Buying a Call
What is the difference between a put and call credit spreads?
- The maximum profit for credit spreads ( bull and call ) is the premium collected
- The maximum loss for credit spreads ( bull and call ) is the width of the strikes
- Iron condors are created by combining a bull put credit spread and a bear call credit spread
- Both are defined risk strategies
Bull Put Credit Spreads –
- Set up by selling a short put at a higher strike price while buying a long put at a lower strike price
- The width of the strikes will define your risk
- The premium collected is your maximum profit
- You will profit as long as the price of the stock is greater than the short strike plus your premium collected.
Bear Call Debit Spreads –
- Set up by selling a short call at a lower strike price while buying a long call at a higher strike price
- The width of the strikes will define your risk
- The premium collected is your maximum profit
- You will profit as long as the price of the stock is less than the short strike minus your premium collected.
Iron Condor –
- Notice that when you combine a bull put spread and a bear call spread, you get the pay-off diagram for an iron condor.
The Greeks
How Does a Credit Spread Change with Volatility and Time
The short option is generally closer to ATM than the long option and is therefore mostly a SHORT option strategy:
- The short option exhibits the dominant behavior with respect to time and volatility for a credit spread
- Short options benefit from the passage of time
- Short options benefit from a drop in volatility
- Short options should be written in periods of high implied volatility
- Delta – Delta represents the change in an option price for every 1 dollar move in the underlying stock. A short put benefits from a move up in the stock price ( positive value ) . A short call benefits from a move down in the stock price( negative value )
- Negative Gamma – Gamma represents the rate of change in delta. A large gamma means that Delta is changing very rapidly. And the option price will lose more and more value for every dollar move in the wrong direction while the profit for every 1 dollar move in the right direction will become smaller and smaller. Gamma will increase the closer you are to expiration. Therefore you, the option will lose more value faster as you reach expiration
- Positive Theta – Credit spreads benefit from the passage of time. Both have positive Theta. The positive value of Theta ( for short options ) accelerates as you approach expiration.
- Negative Vega – Short options benefit from drops in implied volatility. Vega represents the change in an option price for a change in implied volatility. The value of both call and put credit spread options value will decrease with a increase in implied volatility. And vis versa.
Buying a Call
Profit and Loss Chart
- Maximum Profit Potential: Unlimited
- Maximum Loss Potential: Premium Paid for the Call
- Expiration Breakeven Price: Call Strike + Premium Paid for Call
- Estimated Probability of Profit: Less Than 50%
- Assignment Risk?
Buying a Call
Management and Adjustments
- Maximum Profit Potential: Unlimited
- Maximum Loss Potential: Premium Paid for the Call
- Expiration Breakeven Price: Call Strike + Premium Paid for Call
- Estimated Probability of Profit: Less Than 50%
- Assignment Risk?
Credit Spreads
- Max Profit= premium
- Maximum Risk = ( width of the strikes – premium )
Debit Spreads
- Max Profit= ( width of the strikes – premium )
- Maximum Risk = premium
Vertical Spreads
How Do You Set Up a Vertical Spread?
Bear Call Spread ( credit spread )
- sell a call at lower strike while buying a call at a higher strike
- buy a call at a lower strike while sell a call at a higher strike
Bull Put Spread ( credit spread )
- Sell a call at a higher strike while buying a put at a lower strike
Bear Put Spread ( debit spread )
- Buy a put at a higher strike while selling a put a a lower strike
Long Horizontal Spread - neutral strategy
Vertical Spreads
How Do You Set Up a Horizontal Spread?
Short Call Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Short Put Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Long Horizontal Spread - neutral strategy
Diagonal will vary in both expiration date as well as strike price
- Diagonal spreads try to take advantage of both price movement, implied volatility, and time.
- The most complicated of the different spreads
Vertical Spreads
How Do You Set Up a Diagonal Spread?
Diagonal will vary in both expiration date as well as strike price
- Set up as vertical spreads but at different strike prices and expirations
- sell a call in a back or distant month
Short Call Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Short Put Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Option Basics
Tips and Tricks
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
Buying ITM -in the money call options will
- Increase the amount of directional exposure since in the money options have deltas closer to +1
- ITM options are less affected by theta decay
Introduction
Same risk profile as a short put
Use to reduce the cost basis if you want to purchase a stock by selling a put against the purchase
You need to think of this in contrast to buying a stock outright
Setting Up a Covered Call
FYI- Would rather use strategies that sell premium rather than using debit spreads
Set up in low volatility environments
Straddle the stock price
Buy an ITM option and Sell an equidistant or slightly closer OTM option
Set up so that the break even is just around the stock price or ideally even just a little bit better
Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success
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