What Is a Credit Spread in Options Trading?

Foundational Option Concepts

An option contract is a financial derivative instrument that grants the holder a specific right, but not an obligation, to engage in a transaction involving an underlying asset. This underlying asset can be stocks, bonds, commodities, or currencies. The value of an option is derived from the price movement of this underlying asset.

There are two primary types of option contracts: call options and put options. A call option provides the holder the right to purchase the underlying asset at a predetermined price. Conversely, a put option grants the holder the right to sell the underlying asset at a predetermined price.

Several key terms define an option contract. The strike price is the specific price at which the underlying asset can be bought or sold if the option is exercised. The expiration date marks the final day on which the option contract remains valid and can be exercised.

The premium is the price paid by the buyer to the seller for the option contract. This premium is influenced by factors such as the underlying asset’s current price, the strike price, the time remaining until expiration, and the volatility of the underlying asset.

The Core of a Credit Spread

A credit spread is an options strategy that involves the simultaneous sale of one option and the purchase of another option of the same type, either both calls or both puts. These options typically have different strike prices but often share the same expiration date. A credit spread results in a net cash inflow to the trader’s account when the position is established.

The term “credit” signifies that the premium received from selling one option is greater than the premium paid for buying the other. This difference represents the initial profit collected by the trader.

The general structure involves selling an option with a higher premium and simultaneously buying an option with a lower premium. The sold option is typically closer to the money, meaning its strike price is nearer to the underlying asset’s current market price, making its premium higher due to a greater probability of expiring in the money. The purchased option, often further out of the money, serves to define and limit the potential maximum loss of the strategy.

This strategic combination creates a defined risk profile, as the maximum potential loss is known at the time the trade is initiated. The net credit received upfront helps to offset potential losses. The primary goal is for both options to expire worthless, allowing the trader to retain the initial net premium received.

Call and Put Credit Spreads Explained

Call Credit Spreads

Call credit spreads are established by selling a call option and simultaneously buying another call option with a higher strike price. This strategy is generally used when a trader anticipates a neutral to slightly bearish movement in the underlying asset’s price, expecting it to stay below the strike price of the sold call option.

The maximum profit for a call credit spread is limited to the net premium received. For example, if a trader sells a call for $2.00 and buys another call for $0.50, the net credit is $1.50 per share, or $150 for a standard 100-share contract. This profit is realized if the underlying asset’s price remains below the strike price of the sold call option at expiration.

The maximum loss for a call credit spread occurs if the underlying asset’s price rises significantly above the purchased call option’s strike price. This loss is calculated as the difference between the two strike prices minus the net credit received. For instance, if the sold call has a strike of $50 and the purchased call has a strike of $55, with a net credit of $1.50, the maximum loss would be ($55 – $50) – $1.50 = $3.50 per share, or $350.

Put Credit Spreads

A put credit spread involves selling a put option and simultaneously buying another put option with a lower strike price. This strategy is typically employed when a trader expects a neutral to slightly bullish movement in the underlying asset’s price, anticipating it will remain above the strike price of the sold put option.

The maximum profit for a put credit spread is also the net premium received. If a trader sells a put for $1.80 and buys another put for $0.40, the net credit is $1.40 per share, or $140 for a 100-share contract. This profit is achieved if the underlying asset’s price stays above the strike price of the sold put option at expiration.

The maximum loss for a put credit spread occurs if the underlying asset’s price falls significantly below the purchased put option’s strike price. This loss is determined by subtracting the net credit received from the difference between the two strike prices. For example, if the sold put has a strike of $45 and the purchased put has a strike of $40, with a net credit of $1.40, the maximum loss would be ($45 – $40) – $1.40 = $3.60 per share, or $360.