Credit Spreads

A credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time but have different strike prices. Puts are used if you are bullish on the underlying stock or index, while calls are used for a bearish outlook. For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying's market price than the purchased option and therefore has a higher premium. This results in a net credit. The goal of a credit spread position is to retain this net credit by having both options in the spread expire worthless.

This strategy allows investors to achieve both steady rewards and controlled risks. This is accomplished by collecting premium up front and waiting until expiration, when hopefully the positions expire worthless. With credit spreads, the effect of time decay is working for you, not against you.

Credit spreads offer two primary advantages over straight put or call purchases. First, by using out-of-the-money options, you can profit from a wide range of outcomes, including the market moving somewhat against your expectations. If you initiate a bearish credit spread with the sold call option two percent out of the money, you will keep the entire premium if the underlying stock or index moves down, stays flat, or goes up two percent. Only when the sold option slips into the money is your position at risk of losing value. In addition, losses are usually capped at the difference between the strike prices of the options minus the premium collected. This will become clearer in the example below.

The second advantage is that no commission costs are incurred to exit your most successful trades. This occurs when both options expire worthless, allowing you to retain the full credit. Worthless options require no closeout and hence do not incur commission costs. This feature thus increases your net return on a winning credit spread trade.

Normally, a credit spread investor trades front-month options only, as the time decay 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 allow less time for the underlying to move substantially against you. Such a move has a far more negative impact on a credit-spread position than the benefits of having the underlying move for you.

We have found that it is normally considered more beneficial for the credit spread investor to use index 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) gives you much less ability to manage risk in equity option credit spreads. Note that it is not always appropriate to initiate a credit spread trade 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.

We have achieved excellent trading results using options based on indices, specifically the S&P 100 Index (OEX) and the Nasdaq 100 Trust (QQQ) in Bernie Schaeffer's Wealthbuilder service. These options generally have higher trading volumes, making them more liquid. This often leads to smaller bid/asked spreads, which can result in larger initial credits. Also, because they are comprised of many equities, these index-based options are less susceptible to event risk (e.g., earnings reactions) that can adversely impact individual stocks.

Let's look at a bullish credit spread example using OEX puts. With the OEX trading at 650, you sell a front-month OEX 630 put for 4.25 and simultaneously buy a front-month OEX 625 put for 3.50. The resultant credit is 3/4 (4.25 collected minus 3.50 paid out), or $75 per pair of spread contracts. There is a margin requirement for credit spreads equal to the difference between the strike prices minus the credit collected. In this case, the spread of five points (630 minus 625) and credit of 3/4 equates to a margin of $425 per contract: (5 - 3/4) x 100.

The return for a credit spread is calculated by dividing the credit by the margin. Thus, the potential maximum return on margin for this trade is 17.6 percent ($75/$425).

There are a number of possible outcomes for this trade.

The ideal outcome is for the OEX to stay at 630 or higher, in which case both puts will expire worthless and you retain the credit of 3/4. Given that the OEX was at 650 when the spread was initiated, this is also the outcome that has the highest probability of occurring. The breakeven point for the trade is at OEX 629.25, as the 3/4-point liability for the sold put exactly offsets the credit received when the trade was initiated. Below OEX 629.25, this trade incurs losses that increase to a maximum of 4-1/4 at OEX 625. At this point and below, both puts increase in value equally and the added liability of the sold put is exactly counterbalanced by the increasing value of the purchased put. Thus, the maximum loss is capped at the strike of the purchased put (note how the losses at OEX 625 and 624 are the same).

We can also view this trade graphically (see the profit/loss chart below for a 10-contract trade). At first, it may appear daunting that the maximum gain of $750 is dwarfed by the maximum loss of $4,250. It's important to keep in mind, however, that losses will only occur if the underlying stock or index moves significantly against you. For this example, the OEX would have to drop 20 points (over three percent) by expiration before you would begin to experience a loss. In addition, you can always exit the trade by selling your purchased put and buying back the sold put. Though such an exit could be costly, especially in terms of commissions, it is usually a far better outcome than losing your entire margin.

Before adding the power of credit spreads to your options trading toolbox, here are a few points to keep in mind.

First, as with all options, your assessment of the underlying stock or index is the most important factor. For credit spreads, the only objective is for the sold option to stay out of the money. This means that you can be less precise in your assessment of the underlying, a luxury not afforded to a straight option purchase. This also means that credit spreads can be profitable in a range-bound market environment, as out-of-the-money spreads can profit from the lack of a directional move. Nevertheless, for bullish spreads, make sure that there is solid downside support above the strike of the sold put (e.g., a moving average, heavy put open interest, the bottom of a trading range, etc.) to increase the probability that the options finish out of the money. The opposite would be the case for a bearish spread using calls - look for overhead resistance below the strike of the sold call.

Second, make sure that the spread is initiated at strikes that are sufficiently out of the money. In other words, give yourself a cushion so that the position can withstand a move against your expectations. The trade above, for example, incorporated a cushion of over three percent. Note that volatility becomes an issue. If market volatility is high, you may have to build in more cushion to avoid getting whipped out of your position. Credit spreads are thus better suited for a low-volatility environment.

Third, adjust your spread width to allow enough premium to match the risk of the trade. For the OEX, if five points 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. QQQ offers the added flexibility of allowing spreads in one-point increments over a range of strike prices.

Finally, as with all option trades, it is important to consider transaction costs. This is especially true with spreads where two commissions are incurred to open the trade. For example, commission costs will likely take a major chunk out of a $75 credit if you just play one contract. Thus, you may want to consider several contracts as a minimum play to make a spread trade worthwhile.