Option Credit Spreads Explained

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

bull credit spread

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.

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Bear Call Credit Spread

bear 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.


How To Set Up Credit Spreads In A Broker Platform:

6 Replies to “Option Credit Spreads Explained”

  1. 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.

    1. 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.

  2. 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

    1. 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.

  3. 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.

    1. 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.

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