Option Trading: Credit Spread Strategies

A credit spread is a type of vertical spread. It is a trading strategy in which you are buying an option, call or put, at a certain strike price, and simultaneously selling the same type of option at a different strike price of the same month. The sold strike price must have a higher value thus creating a credit at the time the trade is placed. As time goes on the options premium will depreciate, and as long as the price of the stock does not go past the sold strike price at the end of expiration, you keep the full credit. There are two main ways to trade credit spreads – either a low capital risk trade or a high probability trade.

The low capital risk trade consists of making a trade using in the money (ITM) options or at the money (ATM) options to compose the credit spread. For example a stock trading at $55. You are bearish on this stock feeling that it will fall below $50 and stay there. You create a credit spread using calls called a Bear Call Spread. You would sell an ITM $50 call for $5.75 and then buy an ATM $55 call for $2.00 creating a credit for $3.75. The max value of the spread, the difference between strikes, is $5 (55-50), which makes your max risk is $1.25 (5-3.75). This is the low capital risk your are making $3.75 while risking $1.25 which makes for a 300% rate of return. So a high rate of return a low capital risk, what could be wrong with this trade? The probability of success. The stock needs to be below $50 and stay below $50 at the expiration of the options in order to be a successful trade. You need to be correct in your assessment of the direction of the trade.

The high probability trade consists of making a trade using out of the money (OTM) options to compose the credit. Using the same example of a stock trading at $55 that you are bearish, feeling it will fall and stay below $50, we create a different type of credit spread. To create the credit spread, you would sell an OTM $65 Call for $1.10 and buy an OTM $70 Call for $.50 creating a credit of $.60. The max value is still $5 which makes your risk $4.40, much higher than the previous example. This makes for a high capital risk making only $0.60 while risking $4.40 which makes for a 13% rate of return. The difference however is in the probability of the trade being successful. The stock will need to close below $60 at expiration of the options and since it already is below $60 and you feel the stock is weak and will be going lower. The probability of it gaining 10 points or 18% is unlikely in comparison to the previous low capital risk trade in which the stock is at 55 and has to fall 5 points and stay below $50 for the trade to be successful, which makes this credit spread a high probability of success.

Low capital risk but also a low probability of success for the beginner or a higher capital risk with a high probability of success makes for the two choices for the credit spread trader. The choice depends on the traders personality a more involved trader one that really likes to pay close attention to his trade and can make adjustments when necessary may prefer the low capital risk trade. The trader trading part time or is more conservative in their trades one that likes to place a trade and then just monitor it once daily would be more likely to choose the high probability trade. Which type of trader are you?