Credit Spread Strategy Basics
A credit spread consists of the simultaneous purchase and sale of puts (or calls) that expire at the same time but have different strike prices. The mechanics of this strategy are simple - because the strike price of the sold option is closer to the underlying stock's price, it will carry a higher premium than the purchased option, resulting in a net credit in the investor's account. The ultimate goal of a credit-spread strategy is to retain this net credit by having both options in the spread expire worthless. A bullish credit spread employs put positions; a bearish credit spread will use call options.
Credit spreads enable investors to achieve both steady rewards and controlled risks. This is accomplished by banking the premium up front and simply waiting until expiration, when the positions, hopefully, expire worthless. With credit spreads, the impact of time decay is working for you, not against you. Ideally, the credit-spread strategy can yield a winning percentage of 75 to 80% if out-of-the-money options are used to open the spread. As a result of this lowered risk, reward will also be reduced; most credit-spread profits will be in a range between 10 and 25%.
Credit Spread Advantages
In addition to lowered risk, credit spreads offer 2 primary advantages over straight put or call purchases. First, the use of out-of-the-money options means that an investor can profit from a wide range of outcomes, including a modest move in the wrong direction. For example, if a bearish credit spread is initiated by selling a call option 2% out of the money, the entire premium on that option will be retained if the underlying stock moves lower, stays flat, or rises up to 2%. Only when the sold option moved in the money is the overall spread at risk of losing value. Credit-spread losses are usually capped at the difference between the strike prices of the options played minus the premium collected.
The second advantage over straight call and put purchases is that no commission costs are incurred when closing the most successful credit spreads. Both options ideally expire worthless, requiring no further action from the credit-spread player, who merely holds onto the initial credit collected. Worthless options require no closeout and hence do not incur commission costs. This perk essentially increases the net return on a winning credit spread trade.
Typically, a credit-spread investor uses front-month options, to better take advantage of time decay, which evaporates most rapidly in the final month ahead of expiration. The quick time erosion benefits credit spreads, assuming no change in the other variables that affect option pricing - underlying security price, volatility, dividends, or interest rates. Plus, with their limited life spans, front-month options build in less time for the underlying equity to move substantially against the direction of the spread.
We have found that it is often more beneficial for the credit spread investor to use index or exchange-traded fund (ETF) options rather than equity options. A gap in one component of an index will not unduly affect that index, while an equity that gaps sharply in the wrong direction (i.e., on an earnings report or a restructuring plan) leaves a trader much more vulnerable. Even when trading indexes and ETFs, one will not always find a good credit-spread opportunity in every expiration month. Successful credit-spread investors will identify periods of excess short-term volatility and avoid these periods, as there is a risk of getting whipped out of a trade in a volatile environment.
Margin Requirement:
A margin account, set up with one's broker, is required before trading credit spreads. The minimum required in margin equals the difference between the strike prices of the sold and purchased options less the credit received. This value is then multiplied by 100. For example, if a credit spread is initiated by selling a 100-strike put and buying a 95-strike put, at a credit of $0.75 per contract, the margin requirement would be $425 per pair of contracts, or $100-$95 minus $0.75, times 100. The percentage return for a credit-spread trade is calculated by dividing the credit pocketed by the margin requirement.
Credit Spread Example (Bullish):
The XYZ exchange-traded fund – trading at 157 - has displayed positive price action and is moving slowly higher during a period of market torpor. The fund enjoys solid downside support at the 150 mark, site of its 10-week moving average and robust put open interest.
With 2 weeks until options expiration, the credit-spread trader opens a position by selling a front-month 150 put and buying a front-month 145 put. Note that both of these puts are out of the money and will remain so even if XYZ falls to support at 150, a 4.5% drop from current levels. Because the sold 150 put is closer to the money than the purchased 95 put, its premium is higher. Thus, more premium is collected than paid out, resulting in a net credit.
Facts of the trade:
- XYZ ETF trading at 157
- Perceived technical and options support around 150
- Sold front-month 150-strike put for 1.75 (7 points out of the money)
- Purchased front-month 145-strike put for 1.25 (12 points out of the money)
- Initial credit = 0.50 (1.75 collected minus 1.25 paid), or $50 per pair of spread contracts
If XYZ advances, stays flat, or even drops 7 points within the ensuing 2 weeks, the put options used in the spread will remain out of the money and expire worthless, keeping the $50 per pair in the trader's account. The break-even point for this hypothetical trade would occur when XYZ hits $149.50 (the strike of the sold put minus the $0.50 credit). Below breakeven, losses will increase to a maximum of $450 (the difference in strike prices minus the credit collected). Using the formulas from above, the return on this trade is minimum margin of $450 divided by the credit of $0.50, or 11.1%.
The opposite scenario would hold true for a bearish credit spread using calls out-of-the-money calls (e.g., 160 and 165-strike calls) would stay in out-of-the-money territory provided that XYZ moved lower, stayed flat, or advanced fewer than 3 points.
Credit Spread Tips:
As with all options trading, index, ETF or stock selection is the most important factor in selecting a credit-spread candidate. The only objective for this strategy is for the sold option to stay out of the money at expiration. This means that precision is not as important with a spread trade as it is with a straight option sale or purchase. It also means that credit spreads can be a profitable alternative in a range-bound market, as out-of-the-money credit spreads can profit from the lack of a directional move. Regardless, for bullish spreads, make sure there is an element of downside support (e.g., moving averages or heavy put open interest). This will increase the chances of an out-of-the-money finish for the sold put. The opposite is true for a bearish spread that utilizes call positions – the best spread candidates will be facing overhead resistance.
A credit spread should be initiated with options that sufficiently out of the money, as this provides cushion in the case of a modest move against expectations. If market volatility is high, a larger cushion may be desirable to avoid getting whipped out of positions. Credit spreads are better suited for a low-volatility environment.
It's important to adjust the spread width to provide enough premium to match the risk of the trade. When trading index options, for example, if a 5-point spread doesn't provide enough credit, look at a 10-point spread. Remember that the wider spread will also have a greater loss potential and a larger margin requirement.
Finally, as with all option trades, it is important to consider transaction costs. This is especially true with spreads, where 2 commissions are incurred to open the trade. For example, commission costs will likely take a major chunk out of a $75 credit if a single contract is played. In some cases, it may take several contracts as a minimum play to make a credit-spread trade worthwhile.
