In finance, a credit spread, involves a buy of one option and a sale of another option in the same class and expiration but different strike prices. The strike price of the option that is sold is closer to the market price than the option that is bought. Thus a profit is generated. Investors receive a net credit for entering the position, and want the spreads to expire worthless for an overall profit.
Credit spreads can be bullish or bearish. For bearish positions you use calls, for bullish positions you use puts.
For example - One uses a credit spread as a conservative strategy designed to earn modest income for the trader while also having losses totally limited. It involves concurrently buying and selling options on the same security/index in the same month, but at different strike prices. (This particular trade is also called a vertical spread)
If the trader is BEARISH (expects prices to fall), or not rise much, he/she utilizes a bearish call spread. It's called this because you're buying and selling a call and taking a bearish position.
Call Credit Spread Example
Trader Joe expects XYZ to fall from its current price of $35 a share.
Joe sells (writes) 10 January 36 calls at 1.10. Credit = $1100
Joe buys 10 January 37 calls at .75 ($ 750). Cost = $750
Net credit $350
Now consider the following scenarios:
The stock drops or stays BELOW $36 by expiration. In this case all the options expire worthless and Joe keeps the net credit of $350 minus commissions.
If the stock increases above $37 by expiration, Joe must unwind his position by buying the 36 calls BACK, and selling the 37 calls he bought; this difference will be $1, the difference in strike prices. For all 10 calls this costs Joe $1000; when Joe subtracts the $350 credit, this gives Joe a MAXIMUM Loss of $650.
If the closing price was between 36 and 37 either Joe's loss would be less or his gains would be less. The "breakeven" stock price would be $36.35: the lower strike price plus the credit for the money he got up front.
Put Credit Spread Example
If the trader is BULLISH, he/she sets up a bullish credit spread with puts. Look at the next example.
Trader Joe expects XYZ to rally sharply from its current price of $20 a share.
Joe sells (writes) 10 January 19 puts at $0.75 - revenue = $750
Joe buys 10 January 18 puts at $.40 - cost = $400
Joe's net credit = $350
Consider the following scenarios:
If the stock price stays the same or goes up sharply, both puts expire worthless and Joe keeps his $350, minus commissions he paid for the options
If the stock price alternatively, falls to below 18 say, to $15, Joe must unwind his position by buying back the $19 puts at $4 and selling back the 18 puts at $3 for a $1 difference, costing him $1000. Minus the $350 credit, his greatest loss is $650.
A closing stock price anywhere between $18 and $19 would give Joe a smaller loss or smaller gain; the breakeven stock price is $18.65, which is the higher strike price minus the credit.
NOTICE IN BOTH cases the losses and gains are strictly limited. This is a awesome strategy for earning a modest amount of income from a portfolio that can be employed to augment your wages, dividends, or social security payments provided you're mindful of the limitations.
Most people get lured into options because of the huge POTENTIAL gain. But what they do NOT realize is the large gains seldom materialize. The average investor only wins 30% of the time. What they fail to do is to consider the probability of success of getting a high gain. They are told to make sure they have a reward to risk ratio of at least 2:1. BUT they are never told to consider the probability of success!!! What good does it do to have a high reward to risk ratio if the probability of success is only 10% or less.
The trading strategy below insures a monthly gain of 3 to 8% with a success rate of 99+%.
After spending hundreds of hours analyzing how the market moved weekly for 25 years, I’ve developed what I call the Remarkable Iron Condor Strategy.
It has the following characteristics:
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