If you have ever read about options or listened to any of the option traders you must have come across the term "option spreads" or " credit spreads". They are a very popular option trading strategy along with covered calls for all new traders. It is relatively easier to understand and they are safe for newer traders since the risk is defined at trade entry.
So what is a credit spread? It's essentially selling a call or put option that is closer to the price of the security and buys a call or put option respectively at a more distant price when compared to the actual price of the underlying. Depending on whether you do call options for your spread or put options, you will have a call credit spread or put credit spread.
Let's take a looks at an example. Let's say Apple is trading at 200$. Then you can sell a 210 call option and buy a 215 call option to create a call credit spread. Similarly, you can also sell a 190 put option and buy a 185 put option to trade a put credit spread.
But why do we say a "credit" spread? It's because we actually get a credit, the difference between the sold option and the bought option at the time of entry. Since we sell options that are closer to the stock price, they will have a higher value than the options we buy further out of the money. Hence we net a credit. This is the maximum amount of profit we can make in a trade.
For example:
190 put in the above example would be trading for say 1.00$ and 185 put is trading for 0.50$. Then we will have a net credit of 1.00 - 0.50 = 0.50$ credit; which is equivalent to 50$. This is your maximum profit. Ok, then how about the maximum risk? Well, the maximum risk in the trade will be the distance between the strike prices and the credit you received. So here we have a 5$ wide strikes between 185 and 190 put option and we received a 0.5$ credit. Hence the total risk is 5-0.5 = 4.5$ worth of risk of 450$
You might think, well, that's a bad risk-reward. I agree, however you need to think about the probability of success. Given that you have a 50-50 shot of making money when you buy or sell a stock you have a very high probability of making money selling these out of the money options. With a proper adjustment technique, you could manage your losses and have a positive expectancy in the long term.
I will reserve credit spread management techniques for a future post.
So what is a credit spread? It's essentially selling a call or put option that is closer to the price of the security and buys a call or put option respectively at a more distant price when compared to the actual price of the underlying. Depending on whether you do call options for your spread or put options, you will have a call credit spread or put credit spread.
Let's take a looks at an example. Let's say Apple is trading at 200$. Then you can sell a 210 call option and buy a 215 call option to create a call credit spread. Similarly, you can also sell a 190 put option and buy a 185 put option to trade a put credit spread.
But why do we say a "credit" spread? It's because we actually get a credit, the difference between the sold option and the bought option at the time of entry. Since we sell options that are closer to the stock price, they will have a higher value than the options we buy further out of the money. Hence we net a credit. This is the maximum amount of profit we can make in a trade.
For example:
190 put in the above example would be trading for say 1.00$ and 185 put is trading for 0.50$. Then we will have a net credit of 1.00 - 0.50 = 0.50$ credit; which is equivalent to 50$. This is your maximum profit. Ok, then how about the maximum risk? Well, the maximum risk in the trade will be the distance between the strike prices and the credit you received. So here we have a 5$ wide strikes between 185 and 190 put option and we received a 0.5$ credit. Hence the total risk is 5-0.5 = 4.5$ worth of risk of 450$
You might think, well, that's a bad risk-reward. I agree, however you need to think about the probability of success. Given that you have a 50-50 shot of making money when you buy or sell a stock you have a very high probability of making money selling these out of the money options. With a proper adjustment technique, you could manage your losses and have a positive expectancy in the long term.
I will reserve credit spread management techniques for a future post.
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