Credit spreads are so named because you receive a credit to your account when executing these kinds of option trades. Each option specifies a price at which the option holder may buy or sell the underlying market and this is known as the strike price. This spread trade generates a credit by utilizing options with different strike prices. Ultimately, the vertical credit spread is a strategy designed to lower risk when selling options.
Sell an option that is slightly out of the money. If selling a call option, the option should be above the current market price. If selling a put, it should be below the current market price. The call spread is a bearish strategy, while the put spread is a bullish strategy. Additionally, both spreads will profit if the market remains flat.
Buy a corresponding option further out of the money. Credit spreads involve buying and selling options of the same type. Therefore, if you sell a call option, buy a corresponding call in the same market with a strike price higher than the call you sell. The same concept applies to put spreads, except you buy a put with a lower strike price than the one you sell.
Wait for the options to expire. If both options are still out of the money at expiration, they expire worthless and the trade essentially closes itself. If the market moves against you, your maximum loss is defined by the difference between the two option strike prices less the credit you received for opening the trade. If this happens and the buyer exercises his option, you may simply exercise the option you bought to offset the position.
Tips
Call options give the buyer the right to buy the underlying market while put options give the buyer the right to sell or short the underlying market. If the buyer exercises her option, the option seller is obligated to take the other side of the trade.
You may increase your position size by adding additional options. For example, you could execute a spread by selling five calls and buying five calls.
Execute the vertical credit spread as a single spread trade rather than two separate trades to get a good fill on the order.
The purpose of buying a corresponding option is to reduce risk by having an offsetting position in place. If the market goes against you, this technique limits your losses.
References
Tips
- Call options give the buyer the right to buy the underlying market while put options give the buyer the right to sell or short the underlying market. If the buyer exercises her option, the option seller is obligated to take the other side of the trade.
- You may increase your position size by adding additional options. For example, you could execute a spread by selling five calls and buying five calls.
- Execute the vertical credit spread as a single spread trade rather than two separate trades to get a good fill on the order.
- The purpose of buying a corresponding option is to reduce risk by having an offsetting position in place. If the market goes against you, this technique limits your losses.
Warnings
- As expiration draws close, beware of the short leg as the stokc price moves above (for a call) or below (for a put) the strike price. It is very likely that the spread will move against you under that circumstance.
Writer Bio
Adam Parker is a writer from Virginia. He holds a Bachelor of Science from James Madison University. Parker has written articles for online sources including The Motley Fool, Gameworld Network and Glossy News.