Unlimited Theoretical Risk!
Selling short options is a a great way to collect premium upfront — the way insurance companies do. You collect a small amount upfront — so long as there is no big accident (ie stock goes above the strike price of that option you sold), you get to collect that premium and the option is worth $0 to your counter-party.
But the problem here is the “what if” scenario. What if that accident (stock goes above the strike price of that option you sold) happens — you will lose a TON of money. Can we mitigate that risk?
That’s where credit spreads come in. It’s not for free though. You’ll have to take a counter-position — buy an option, but ideally farther out strike-price and at a lower price than the option you sold. Should the BIG accident occur and you lose a lot of money on that first option you sold, no worries. Your second, cheaper option you purchased cancels out the losses — essentially capping your losses.
And should no big accident occur, you collect your option premium like normal.
End result? Rather than collecting a full premium (as from a simple option short), you collect “net credit”. Net Credit = Full Premium – Cost of Insurance Option.
What did you get in return for this slightly lower amount you get to collect upfront? Protection against infinite loss, or having a defined max loss when “accidents” occur. These credit spreads are essentially safer versions of simply selling an option (which lets you collect money upfront – yours to keep so long as that option value doesn’t spike up).
Let’s dive deeper and look at 3 different definitions for a credit spread.
A credit spread is (most commonly) a 2-legged option trade of the same underlying stock/index with the same option expiration date — but the difference is that each option leg has a different strike price, resulting in a spread difference in value between these two strikes.
Credit = Collect money now (but doesn’t mean you’ll necessarily keep it)
Bull = Your market view. You bet the underlying will stay positive (or at least neutral) relative to strike price of the option you shorted.
Put = Someone else thinks the underlying will go down but you don’t think so since your market view is bullish, so you’re happy to sell him this “put”. You make money so long as things stay positive (or at least neutral).
Spread = Adding in the second cheaper counter-option (put), but buying it rather than selling, you cap your losses, enabling a pre-defined risk on the bet. The net of the two options (higher priced put that you sold MINUS lower priced put that you bought) gets you the “credit spread” that you collect today.
These are paired option trades that involve taking two “put” positions — both with strikes lower than where the stock is trading at. One put will have a higher-strike price that you SELL, the other will have a lower strike price that you BUY. You can think of the higher-strike price put as your main bet, while the second “lower-strike price” put as your insurance — limiting your losses.
You sell the higher-strike put (worth more since it’s closer to where the underlying is trading at) while simultaneously buying the lower-strike put (cheaper since it’s farther from where the underlying is trading at) in one single transaction. This results in a net “credit” – positive gain that you can collect now. With these two positions, here are your 3 outcomes. The underlying stock…
1: … falls and trades below the “lower-strike price”: The lower strike price put makes money while the higher-strike price put loses money — essentially canceling each other out resulting in a neutral outcome once the underlying stock falls below that lower strike price. You essentially outline a “limit” for your losses should the stock price fall below this strike price — enabling a “pre-defined risk” or “pre-defined loss” outcome here.
2: … stays above the “higher-strike price”. This is your “bull-ish” bet that the underlying stock will stay above the higher-strike-price. You already collected your premium when selling the higher-strike price put. The lower-strike price put is out-of-the-money and not worth anything (just cost you a small amount). So you get to collect your “net credit” — full amount or “max profit”. Essentially, this “bull-ish” credit spread (with two “puts”), makes you a defined profit when the underlying stock stays “bull-ish” or at least neutral.
3: …falls somewhere between the “higher-strike price” and “lower-strike price”. Here, your “net credit” which is positive will gradually fall toward negative as you get closer to the lower-strike price. There will be a break-even point somewhere in between depending on how much the put options were sold vs bought at the two strike prices. Recall, losses will reach a limit once the stock reaches the “lower-strike price” and below — your loss there is capped.
Let me give you an example.
If the underlying stock or index is trading at 100, then you might short/sell the 95 strike put (collect $2 immediately on this bet that it won’t go below 95) while simultaneously buying the 90 strike put (pay out $0.25 immediately on this bet that it WILL go below 90), resulting in a net credit (+$2 – $0.25 = $1.75)
The 95 strike, because it is closer to where the stock is trading, will typically have more value than the 90 strike, which is further away from where the stock is trading. This difference in value creates a spread and results in a net credit when this single paired transaction is executed ($1.75 in the above example). As long as the stock/index continues trading above 95 (ie stays at 100), then you can lock in your net credit of $1.75. Even if the stock goes way higher to 110, the amount you gained is still the same — at the max of $1.75.
If the stock/index falls between 90 and 95, that net credit will start turning into a net debit, with the breakeven somewhere in between. Once the stock/index falls below 90, the net loss will be capped, thanks to the “small leg” of the trade (buying the 90 strike put directly offsets selling the 95 put at this point). The losses below 90 are capped and the gains above 95 are capped.
This strategy lets you bet that the stock won’t go below 95 (ie “bull-ish”) and the result is largely binary and capped on both the winning side (above 95) and the losing side (below 90). The “capped” nature of this bet makes it a safe risk-defined strategy, worthy of repeated use. In contrary, without that opposing option, you’d have a naked short put which has unlimited losses – a much more dangerous trading strategy.
One shortcut to remember, if you’re bullish (betting stock will remain above a certain price), you want to achieve that goal via selling a put (collecting money now), and buying cheaper (farther out) puts as insurance to limit losses.
Now, you might think, why don’t I do the opposite if I were bearish? Why don’t I “Buy the Expensive Put and Sell the Cheaper Put”?
Well, this creates a “Debit” spread since the result of this trade is that you are negative today. You still get the benefit of a pre-defined loss limit but for you to make money, the underlying stock needs to move in your favor (downward), rather than neutral. Debit spreads require a correct directional view to make money, but credit spreads can make money if your direction is correct OR when the direction is neutral. And you get to collect that money today.
Credit spreads have the second component which acts as an insurance play, capping losses which tremendously improves the risk profile of a trade. Credit Spreads might not have as big a premium to collect (due to the cost of that insurance call) as a naked short, but the defined risk profile gain is well worth it. With risk more manageable, margin requirements at your broker are much much lower.
How much capped loss a credit spread takes in depends on how far out the “farther-out” strike price is of the 2nd option. The farther out it is (cheaper), the bigger the risk. The closer it is (more expensive), the smaller the risk.
Unlike traditional stocks where you make less when the stock moves only a little bit and you make a lot when the stock moves a lot, this credit option spread bet doesn’t behave like that. Rather, your maximum profit is largely binary — if underlying stock is above a certain level, you get 100% of the profit. If underlying stock is below that level, your maximum loss is reached. Even if the stock expires really close to the short strike, AND it doesn’t cross it at expiration close, then we still reach maximum profit — that’s the beauty with credit spreads. Risk is defined AND you don’t have to be all that accurate to collect 100% of the profit.
You are simply betting that the stock won’t be above or below a certain level — how much it is above or below does not matter. All we care about is that short strike level — and if it doesn’t get breached and it expires that way, then we collect maximum profit from that trade.
Options are sensitive to time. The more time available, the greater the chance that the underlying stock could jump up to make a previously “out of the money” call option become an “in-the-money” call option. As more time passes, the time value of this option falls more and more. It accelerates. On the last day before expiration, you will see the biggest decline in the time value of the option. This gradual but then accelerated loss in the value of the option due to time passing, is known as time decay.
With a credit spread, each day the market does or does not move in your favor, your account value will increase slightly until max profit is reached on the day of expiration. Technically, you are long one option and short one option – so it may not be apparent how you are a “net-seller of options” and therefore benefiting from time decay.
The reason is because the option you are short is closer to where the market is at (the basic credit spread mechanics). The time decay here is larger than the time decay of your other option, which is long, but further away from the market price. Because this long option is further away, the time decay for that option is less pronounced than your short option, which is closer to where the market is. Being closer to market price, for an option, means the time value was originally high as there was a “good” probability that the option could go “in-the-money”. But each day that passes and this has NOT happened, the option’s value falls. Compared to the long option farther away — its time value was small to begin with (probability that that long option could become “in-the-money” the next day is small) and so each day that passes will result in a smaller time decay than for the short option that was closer to market price.
As such, even though you are long one option and short the other, you are effectively a “net-seller” of options and are benefiting from time decay. Of course, you would benefit MORE from time decay if you are simply short the option without having that other long option, but in that case, you would also be exposed to unlimited theoretical risk. With credit spreads, you cap your theoretical losses and at the same time are still a net-seller of options, benefiting slightly from time decay.
So because of this time decay benefit, your credit spread position will increase in value more and more as each day passes and the underlying stock does not cross the option’s strike price. While the counter-party’s options time-value decays at an accelerated rate toward $0, your option positions move in the positive direction, at an accelerated rate, toward max profit. Thanks to time decay, your position gradually goes up if nothing else changes — and that’s value you can realize by exiting the position.
A credit spread is a paired option trade where the sale of one option is used to take your dominant view on the market while a counter option is used as insurance protection to limit losses should things go the other way. The resulting credit spread has benefits of