Vertical Credit Spreads are probably the most used option trading strategy out there (especially for high probability options trading). The strategy is very simple to do and only requires a long and a short option contract at different strikes. The Premium received is higher than the amount paid for the long legs, therefore resulting in a net credit. In this article, you will learn everything you need to know about credit spreads.
If you aren’t familiar with options spreads in general, make sure to check out my options spreads article first.
Video Breakdown:
Bull Put Credit Spreads
Market Assumption:
Just like the name indicates this is a bullish strategy. So you should have somewhat of a bullish outlook when trading a Bull Credit Spread. But as you’ll see in the profit and loss section/diagram the price can also stay the same or even move a little against you. So you can also just be very slightly bullish. Depending on how far you go OTM the price can even move down a lot while you still make money. This defined risk strategy is often used for high probability options selling.
Setup:
- Buy 1 OTM Put
- Sell 1 OTM Put (higher strike)
This should result in a credit (You get paid to open)
Profit and Loss:
A Bull Put Credit Spread is both limited risk and limited profit. There is a set maximum loss and profit defined before entry. The max loss is bigger than the max profit. Maximum profit is achieved as long as the price stays above the strike of the short position. Maximum loss happens when the price is below the long strike. The long position acts as a hedge and makes this a defined risk trade.
Maximum Profit: Premium received – Commissions
Ex. $20 Premium – $3 = $17 (max profit)
Maximum Loss: Width of Strikes * 100 – Premium received + Commissions
Ex. (Strike 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max loss)
(a normal option contract controls 100 shares, therefore *100)
Implied Volatility and Time Decay:
Bull Put Credit Spreads profits from a drop in Implied Volatility. This means it is best to use this strategy when IV is high (IV rank over 50) because you then have a higher chance of making money.
Time Decay or Theta works in favor of this strategy and is therefore positive. The more time goes by, the more value the sold option contract loses which is good for this strategy. The closer to expiration, the more time decay there is daily.
Bear Call Credit Spread
Market Assumption:
A Bear Call Credit Spread is best used for bearish or almost neutral conditions. It gives the holder a cushion for the price to move. The price, therefore, has quite a lot of room to move in where this strategy still is profitable. This defined risk strategy is often used for high probability options selling.
Setup:
- Sell 1 OTM Call
- Buy 1 OTM Call (higher strike)
This should result in a credit (You get paid to open)
Profit and Loss:
Just like Bull Put Credit Spreads the Bear Call Credit Spread also is a defined risk and defined profit strategy. The maximum profit is reached as long as the price of the underlying stays lower than the strike of the short position. The maximum loss occurs when the price is higher than the long strike. The max loss is bigger than the max profit. The long contract acts as a hedge to make the risk of this strategy limited.
Maximum Profit: Premium received – Commissions
Ex. $20 Premium – $3 = $17 (max profit)
Maximum Loss: Width of Strikes * 100 – Premium received + Commissions
Ex. (Strike 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max loss)
(a normal option contract controls 100 shares, therefore *100)
Implied Volatility and Time Decay:
A Bear Call Credit Spread also profits from a drop in Implied Volatility and therefore also should be sold when there is high IV (IV rank over 50). This will increase the chances of winning with this strategy.
Time decay works positively for this setup. Every day the value of the sold option loses some of its extrinsic value and therefore increases your chances of keeping the full premium.
Trader’s Note:
Credit Spreads are a very good, easy and versatile option strategy. In fact, they are my favorite and most used strategy up to this point. If they are used correctly, they can be very profitable. Credit spreads are one of the best strategies for high probability trading. I would recommend trading credit spreads only with OTM strikes and with a rather high probability of profit. If this is done, the price will have space to move in. The further the strikes are OTM, the higher the probability of profit becomes. Additionally, the max profit decreases and the max loss increases. Too far OTM strikes will result in very small credits and very high max losses. Therefore these should be avoided.
Hi there,
I find this idea very interesting, but you`ll have to forgive me, what exactly would I be putting a trade on? Stocks/Shares? Oil/gas or other items of value?
Anyway, The idea sounds to be a bit like “matched betting” whereby you put two opposing bets on, and get a net profit. Would that be a fair assumption?
I lookforward to your reply.
Well this is a very common options strategy. It seems to me that you are quite new to options and don’t have a complete understanding of them. To understand this strategy and options in general better check out my free education section HERE.
Hey Buddy! My name is Brad and I am an experienced FOREX trader. I thoroughly enjoyed your information on technical analysis and it seems like you represent yourself as a true chartist. However, my question for you would be how does the fundamental analysis of market action affect your theories? The chart reacts to the news in most sizable trends and the news can be a very good indicator of what the chart will do. Case in point, the EUR/USD has been rising a lot lately (ALTHOUGH IT SHORTED TODAY) and I recognize the political happenings in Washington as the prime indicator of these uptrends. I don’t hate the man, but every time the President opens his mouth the dollar weakens. Especially with the hearings taking place every week. It seems as though the news has something to do with the fluctuation of the markets. I do know that when the Fed increases interest rates a huge USD trend usually follows.
The only problem with fundamental analysis however is that we usually gain access to the news after it is too late. How do you remedy this problem?
Warm regards,
Brad
Hey Brad,
First of all thanks for your comment. To be honest I don’t really believe too much in fundamental analysis. Of course events like elections, referendums, increases in interest rates, announcements etc. will have impacts on the market. But I don’t really believe that the core ideas behind fundamental (reading balance sheets, cash flow statements and more) deliver any kind of edge for traders. Everybody has acces to these and it’s is nearly impossible to find anything new, which no one else has found before. Therefore I do not use fundamental analysis in my trading. Of course I always check what news/events lay ahead (for example: earnings, dividends announcements of the Fed, elections…), but I don’t really trade based on any of these events. I usually just try to avoid some of them. I don’t buy or sell a certain option, based on my findings through fundamental analysis. It is almost important to have a good market awareness (you can find more on that here) and know what will impact your position, but my option trading style really does not rely on any forms of fundamental analysis at all (neither on technical analysis). It is based on the historical overestimation of implied volatility. Basically I sell out of the money options, which expire worthless most of the time. To learn more about my strategy check out my education section (here)
But I do know that things are quite different in Forex. Currencies are much more sensitive to market news and events. But I never really have traded any Currencies before, so I can’t speak too much for that.
I hope this could help you a little. If you have any further questions or comments I would be happy to hear more from you.
Hi, I am interested in credit spreads. It seems you have to have a substantial amount of money in your account to achieve a decent profit. For example, how much would you have to have in your account to produce 5K each month? Also,, is there software that can help with this?
Thanks.
Hey Judith,
Well your profit really depends on your trading style and risk tolerance. A 5K profit per month can be done with many different account sizes. So I am sorry, but I cannot really give you a clear answer to your question. But it is safe to say that you cannot consistently earn 5K a month with a small trading account. If you want you can contact me personally here and send me some more details and I will try to help you a little better.
Hi if I have call debit spread. The stock is trading $247 and my spread strikes are $253 and $254. I understand that I will not loss money unless the stock price moves to the $253 price. The goal is the option expires worthless and I get the credit. My question if the stock starts to move against me right-away on the first day of the trade to $252, what happens if I sell right-away or before expiration? Do I make anything? Thank You Tom
Hi Tom,
Thanks for the question. I believe you were referring to a call credit spread, not a call debit spread. A call debit spread with your strikes would mean that you buy the 253 strike and sell the 254 strike. This would mean that the underlying’s price would have to move above 253-254 for you to achieve a profit at expiration.
If you would sell the 253 call and buy the 254 call, it would be a call credit spread which is a bearish strategy. The breakeven point for this strategy would be somewhere between 253 and 254. The effect of an immediate move against you really depends on the position and the underlying asset. However, generally speaking, you probably would have a relatively small paper loss. So if you close the position then, it would likely be at a loss.
However, like I said, this depends on the position. If you, for instance, had a credit spread with a high negative Vega, you might have no loss or even a profit after such an up-move because implied volatility tends to drop when prices go up.
What you could do (if you have a tastyworks account) is to go to the analysis tab. There you can analyze the payoff diagram of such a spread at and before expiration.
I hope this helps.
Hi, I have a couple questions. One is the account type to setup in tastyworks. Do I have to do the margin account to trade vertical credit spreads? Can I do a cash account and then as I build my account up and it gets over $2000 dollars will it automatically turn into a margin account? I just don’t want to make the wrong move when setting up my account.
My next question is regarding setting up a limit order. Can you provide more of a description on how you would do that in tastyworks? Also, how do you issue the GTC?
Thanks for your help.
Hi Jarrett,
You won’t be able to short sell options without owning the underlying asset in a cash account. This means you won’t be able to trade vertical spreads (or any other options strategies that require you to sell an option) in a cash account. To be able to do this, you need a margin account.
And no, a cash account won’t be turned into a margin account after it exceeds $2000. You will have to open and fund a margin account to trade in a margin account.
By default, tastyworks’ order type is set to limit orders that expire after the current trading session. When trading options, you would have to manually change this in the settings menu. For stock positions, there is a small drop-down menu inside of the order preview at the bottom of the trade tab that allows you to change your order type (right above the big orange Review & Send button).
Right next to this drop-down menu, there is a second drop-down menu that allows you to choose GTC (instead of DAY which is the default order type).
I am currently working on an in-depth guide to the tastyworks platform. I hope I will be able to release it within the next week or so. So keep your eyes open for that.
I hope this helps. Otherwise, let me know.
Hi again Jarrett,
I just published the promised tastyworks tutorial. I hope this helps.
Hi,
If you have a small account, $2000-$3000, how do you manage your position size, 1-5%, using bull put or bear call credit spreads and still make a profit?
Thanks
Hi Greg,
5% of a $3000 account is still $150. It shouldn’t be too hard to find vertical spreads with a risk less than $150. You just have to focus on lower-priced assets with ‘cheaper’ options.
I hope this helps.
Hello, You have good material.
I have a question about any credit option strategy.
When we make a credit spread, buttterfly or Iron condor. Do we get the credit right away to open the trade or do we get it at expiration? If the underline price goes in the opposite direction and the sold trades become ITM. Don’t we receive the credit? Or the option seller always get the credit up front but it may loss it if the trades become ITM?
My confusion is if the option seller has to wait until expiration to get the credit?
Hi Seth,
Thanks for the question. When selling options (or other securities), you are trading on margin (since you are basically selling a borrowed security). That means you can’t directly use the money you received for selling for other purchases.
But generally, you receive the credit when you sell an option, but you only get to keep it if the option position is closed. If, for instance, you sell an option for $5, you will have to close the position by buying it back for less than $5 to achieve a profit. If the option expires worthless, you can keep the entire $5. But most of the time, you will buy it back before expiration for a small amount (e.g. $1 so that you can keep $4 of the collected credit).
I hope this answers your question.
Why buy it back before expiration if letting it expire is more profitable and most options expire?
Usually waiting that extra time just to make a little more isn’t worth it. It can be more efficient to deploy your capital in a new trade.