What is a Credit Spread Strategy?

Last Updated: 21 Jan 2025

The credit spread Options strategy is a simple yet popular trading strategy. It involves buying and selling Call or Put Options with the same underlying asset and expiration date. The strike prices of these Options yield a profit in the form of a net premium. In an Option credit spread strategy, you gain maximum profit when both the Options expire worthlessly.

Here are the types of credit spread strategies and how they work.

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 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.

Market Price	Long/Short Call	Strike Price	Premium	Total premium (Premium x 100)
₹2,000	Short	₹2200	₹400	₹40,000
₹2,000	Long	₹2300	₹330	₹33,000

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.

Anil will earn a maximum profit if the stock price at expiration is below ₹2,200. This is because at any value below ₹2,200, both the Options will expire worthlessly and Anil gets to keep the net premium

If the stock price at expiration is between ₹2,200 and ₹2,300, the short Call will be ‘in the money and Anil will have to sell at ₹2,200. For example, if the stock price is ₹2,220 at expiration, the buyer of the first Call Option will exercise their right to buy at ₹2,200. Whereas, the second Call Option in the credit spread strategy is above 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 ₹7,000 – ₹2,000 = ₹5,000.

A credit spread strategy, however, helps the investor reduce the risk involved as it caps the maximum loss. In this case, even if the prices rise above ₹2,300, Anil can exercise his long Call and his loss will be limited to the width of the spread i.e. ₹100/share

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.

Market Price	Long/Short Call	Strike Price	Premium	Total premium (Premium x 100)
₹2,000	Short	₹2200	₹400	₹40,000
₹2,000	Long	₹2300	₹330	₹33,000

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?

The key benefits are as follows:

• Limited Risk: The biggest benefit of a credit spread is that it is a limited risk strategy. Since your risk is limited to the difference between the strike prices minus the premium, this is considered a limited risk strategy.
• Profit from Time Decay (Theta): You make money from the time decay with credit spreads because long options lose value as the expiration date nears. Sellers can capitalize on this by receiving premiums upfront and allowing time to erode the value of the sold option.
• Versatility: You can trade credit spreads in bull, bear, or neutral market conditions. This allows traders to customize the strategy to their different market views.
• Higher Probability of Profit: With a credit spread, you receive a premium, so the position has a higher probability of profitability. The strategy can be profitable as long as the underlying asset stays within a certain price range.
• Defined Risk/Reward: In contrast to some other strategies, credit spreads offer a known profit potential and a fixed amount of risk, making it easy for traders to plan accordingly.
• Reduced Capital Requirement: Since credit spreads are constructed by selling one option and buying another, they generally require less upfront capital compared to straight long or short positions in the underlying asset.
• Lower Impact of Volatility: Credit spreads are unique in that they can be established with both long and short trades, meaning the overall exposure to volatility can be lowered, providing greater smoothness in uncertain economic conditions.

Market Price	Long/Short Put	Strike Price	Premium	Total premium (Premium x 100)
₹2,000	Short	₹1,900	₹250	₹25,000
₹2,000	Long	₹1,800	₹170	₹17,000x

Risks of Credit Spread Strategy

The credit spread strategy has some drawbacks, and traders should understand the risks before executing it.

• Limited Profit Potential: While the risk is capped, so is the potential reward. The maximum profit from a credit spread is the net premium received, which is relatively small compared to other strategies. This limited reward may not always justify the risk taken.
• Risk of Losses: If the underlying asset moves significantly against the position, the maximum loss can occur. This happens when the price moves past the long option’s strike price, forcing the trader to take a loss that is equal to the difference between the two strike prices minus the premium received.
• Impact of Volatility: While credit spreads can reduce exposure to volatility, sudden market moves or high volatility can still cause the strategy to fail. A sharp price movement in either direction may lead to significant losses.
• Early Assignment Risk: If the position involves options that are deep in the money, early assignment is possible, especially in American-style options. This can lead to unexpected outcomes and force adjustments.
• Missed Opportunities: Credit spreads limit the profit potential, meaning that in strong trending markets, the trader may miss out on significant gains by not capturing the full price movement.

Frequently Asked Questions

1. . How Do You Profit From Credit Spread?

When the spreads are narrow between Options, the credit spread results in a profit.

2. How is credit spread calculated?

Credit spreads are calculated when the net premium is added to the lower strike price. For put spreads, the net premium is subtracted from the higher strike price to earn a profit.

3. What is an example of a credit spread?

An example of a credit spread is a bull put spread, where a trader sells a put option at a higher strike price and buys another put option at a lower strike price. The trader receives a premium upfront and profits if the underlying asset remains above the higher strike price.

4. Are credit spreads profitable?

Yes, credit spreads can be profitable, particularly if the underlying asset stays within a specified price range. The maximum profit is the premium received when opening the position. While the strategy has limited profit potential, it offers a higher probability of success due to its defined risk and reward.

5. What is the best time frame for credit spreads?

The best time frame for credit spreads typically ranges from 30 to 45 days to expiration. This duration provides a balance between time decay (theta) and allowing enough time for the underlying asset to move within the desired range. Shorter time frames may offer quicker results but with higher risk, while longer ones could reduce potential profitability.