What is a Credit Spread Strategy?

Credit Spread Strategy with Call Option:

If Anil is bearish and expects the market price of the underlying asset to go down, he can sell or short a Call Option with a lower strike price and a higher premium. At the same time, he buys a Call Option at a higher strike price for a lower premium. This is Called a Call credit spread Option strategy or bear Call strategy.

For example, Anil sells a Call Option for December 2021 with a strike price of ₹2,000 and a premium of ₹400. Simultaneously, he buys a Call Option for December 2021 with a strike price of ₹2,500 and a premium of ₹330.

At the time of this transaction, Anil has profited from the difference in the premium of both Options. Assuming the multiplier is 100 since every Option trade consists of 100 shares, Anil will earn ₹70 x 100 = ₹7,000 as a net premium.

Credit Spread Strategy with Put Option:

You can use a similar Option credit spread strategy to buy and sell Put Options when the investor is bullish and expects the market price to go up. A Put credit spread strategy or Bull Put Spread involves selling a Put Option with a higher strike price for a higher premium and buying a Put Option for the same asset and expiration date with a lower strike price and premium.

For example, Anil sells a Put Option for a stock trading at ₹2,000 with a strike price of ₹1,900. He charges a premium of ₹250. Simultaneously, he buys a Put Option for the same stock and same expiration date with a strike price of ₹1,800 for a premium of ₹180. At the time of this trade, Anil has earned a net premium of (₹250 - ₹170) x 100 = ₹8,000.

The profit for Anil will be maximum if the stock price at expiration is above ₹1,900. This is because at any value above ₹1,900, both the Options will expire worthlessly and Anil gets to keep the net premium.

If the stock price at expiration is between ₹1,900 and ₹1,800, the short Put will be in the money and Anil will have to buy the stock at ₹1,900. Furthermore, if the stock price is ₹1880 at expiration, the buyer of the first Put Option will exercise their right to sell at ₹1,900. Whereas, the second Put Option in the credit spread strategy is below the stock price, and therefore will not be exercised. So, Anil will have to bear a loss of ₹2,000 (₹20 per share). Thus, his net profit will be ₹8,000 - ₹2,000 = ₹6,000.

Since Anil’s credit spread strategy has a long put with a strike price of ₹1,800, even if the stock price falls below ₹1,800, he can buy the stock at ₹1,800 and sell it at ₹1,900 to the buyer of his short Put. Thus the maximum loss is limited to ₹10,000 [(₹1,900 - ₹1,800) x 100] .

As illustrated above, the principle of a credit spread Option trading strategy is similar to fundamental Option trading. However, by using this strategy, the investor sets a maximum profit and maximum loss. The long Put/Call serves as a safety net in case the market prices move in the opposite direction of their expectations. At the same time, the investor cannot profit more than the net premium even if the market is moving favorably.

What are the benefits of the Credit Spread Strategy?

One of the features that make a credit spread Options trading strategy popular is that it can be used regardless of the movement of market prices. Even when the stock prices increase, decrease or remain the same, you can make a profit by using the correct credit spread strategy. Another reason why investors prefer to employ a credit spread strategy is that it has capped losses. The loss in any credit spread strategy is limited to the width of the spread and therefore it entitles less risk. These spreads are also easy to manage.