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Credit Spreads
What is a credit spread?
A credit spread is an options strategy where a trader sells one option and buys another option at a different strike price, usually collecting a net credit upfront. The purchased option helps define the maximum risk of the position.
Example:
A trader sells a $100 put and buys a $95 put. If the trader collects $1.00, the spread is a $5-wide put credit spread with a $1.00 credit.
Why do traders use credit spreads?
Traders use credit spreads to collect premium while defining risk. Unlike selling an uncovered option, a credit spread has a limited maximum loss because the long option acts as protection.
Example:
Instead of selling a put by itself, a trader may sell a put spread to reduce the amount of capital at risk.
How is max profit calculated on a credit spread?
The maximum profit is usually the credit received when opening the trade, before commissions and fees.
Example:
If a trader collects $1.00 for a credit spread, the maximum profit is $100 per contract before commissions and fees.
How is max loss calculated on a credit spread?
Maximum loss is usually the spread width minus the credit received, before commissions and fees.
Example:
If a trader sells a $5-wide credit spread and collects $1.00, the maximum loss is $4.00, or $400 per contract before commissions and fees.
What is a put credit spread?
A put credit spread is generally a bullish or neutral-to-bullish strategy. It involves selling a put option and buying another put option at a lower strike price.
Example:
Sell the $100 put and buy the $95 put. The trader wants the underlying to stay above the short put strike.
What is a call credit spread?
A call credit spread is generally a bearish or neutral-to-bearish strategy. It involves selling a call option and buying another call option at a higher strike price.
Example:
Sell the $100 call and buy the $105 call. The trader wants the underlying to stay below the short call strike.
Key takeaway
Credit spreads can help define risk, but they still involve real potential losses. Traders should understand the max profit, max loss, breakeven price, expiration date, and assignment or settlement rules before entering a trade.