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How to Use Credit Spreads to Reduce Risk

by | Jan 18, 2020 | blogs, Editorial | 0 comments

Would you like to set your own salary and be your own boss?

Do you have a desire to build a steady stream of income from your trading business?

Trading credit spreads is one of the only ways you can boost consistency and provide a steady stream of income. 

Credit spreads really have it all…  I’m talking about

  • House odds of over 60%
  • Return on Investments of 100%
  • Known risk levels
  • Known profit levels

When placing credit trades you will know exactly how much you are going to make and how much you can lose before hitting send!

Like what you hear so far?  

Let me teach you how it all works…

 

What Are Credit Spreads

 

Credit spreads are an options strategy where you buy and sell options that are

  • The same type
  • The same expiration
  • Different strike prices

There are a lot of useful properties to trading Credit spreads.  Traditionally, they are helpful risk management tools for options traders.  

Credit spreads are unique as they allow options traders to remove a majority of their risk in that position.  Unfortunately, this comes at a cost of significantly limiting the profit potential of the trade.

So what’s the benefit of trading credit spreads then?

Well… you can calculate the exact amount of money you are going to risk at the time you enter the position.  

This is a feature of credit spreads that makes long options traders and stock traders drool over.

Plus credit spreads are one of the most versatile trading strategies… giving options traders the most flexibility when looking to place a bullish or bearish position.

There are two major types of credit spreads:

  1. Credit put spread: A bullish option strategy
  2. Credit call spread:  A bearish option strategy

So how do these two types of credit spreads give me consistent income?

Let’s discuss this in more detail…

 

Credit Put Spreads

 

A credit put spread is an alternative strategy that can be traded as a safer alternative to an uncovered or naked short put option.   

Characteristics of a naked short put option:

  • Short puts are a neutral to bullish trade
  • Limited profits
  • Unlimited losses
  • Require higher capital requirements to trade 

Although risk is “unlimited”, it is technically limited as the trade would lose money until the stock was worth $0 and could not go any lower. 

So nobody likes unlimited risk… so what’s the solution?

To trade a credit put spread instead of a naked put.

Characteristics of a credit put spread:

  • Short credit spreads are neutral to bullish trade
  • Limited profits
  • Limited losses
  • Requires lower capital requirements to trade

In order to trade a credit spread you would look to simultaneously purchase and sell options contracts of the same type, on the same underlying security, across multiple strike prices.

Once a credit put spread is established, the premium you receive from the sale of the short option is greater than what you would pay for the options purchased.  

The Formulas:

Maximum profit (reward) = net premium received

Maximum loss (risk) = higher strike – lower strike – net premium received

Maximum loss (risk) = B/E – lower strike

Breakeven = higher strike – net premium received

Let’s look at an example…

 

Credit put spread

 

Credit put spread example:

  • Buy 1 XYZ June 100 puts @ $1.00
  • Sell 1 XYZ June 105 puts @ $2.00
  • Net credit : $1.00
  • Breakeven :  $104

Credit put spread details:

This spread is executed for a net credit of $1.00 ($2.00 collected for the sale of the 105 puts and $1.00 paid for the purchase of the 100 puts).

Since this is a bullish credit spread, we are looking for the markets to head higher.

Therefore, if the market closes at above the breakeven is calculated at $105 – $1.00 = $104

If the markets head above $105 at expiration, you receive your max profit of $1.00

If the market closes below $100 at expiration, you will end up with a max loss of $105-$100-$1.00 = $4.00

What happens if you sold the June 105 puts uncovered?

You would have initially collected $2.00 instead of $1.00 when placing the trade.  However, the trade-off for increased profits is unlimited downside risk.  

 

How credit put spreads work

 

In order to better understand how the profit and loss characteristics of credit put spreads work, let’s take a look at 5 different price scenarios.

 

Scenario 1 – The stock drops significantly and closes at $50

 

In this scenario:

  • You will need to exercise your 100 puts and sell short 100 shares of XYZ stock
  • Your 105 shares of XYZ stock will be assigned 
  • Required to buy back the short position
  • Bought spread at $100
  • In the case of credit spread, max loss is $4.00

Scenario 2 – The stock drops slightly and closes at $102

 

In this scenario:

  • You will not exercise your 100 puts because they are out of the money
  • The short 70 puts will be assigned and you will be required to buy 100 shares of XYZ at $105
  • Then sell your shares at market price of $102
  • The difference between the buy and sell price is $3.00 
  • Brought in net credit of $1.00
  • Loss will be approximately $2.00

Scenario 3 – The stock closes exactly at breakeven at $104

 

In this scenario:

  • Will not exercise your 100 puts because they are out of money
  • The 70 puts will be assigned and you will be required to buy 100 shares of XYZ stock at $105
  • Sell shares at market price of $104
  • Difference between net credit and sell price is $1
  • Since you received net credit of 1.00 and sell for the loss of 1.00, net loss is actually zero

Scenario 4 – The stock rises slightly, closing at 104.50

 

In this scenario:

  • You will not exercise your 100 puts since they are out of the money
  • The 70 puts will be assigned and require you to buy 100 shares of XYZ stock at $105
  • Sell shares at market price of $104.50
  • Initial credit was $1.00
  • This gain will vary…In this example, $1.00 – .50 = $50 profits

Scenario 5 – The stock rises significantly

 

In this scenario:

  • You will not exercise 100 puts since they are out of the money
  • You will not be assigned 70 puts since they are out of the money
  • In this case all options expire worthless
  • Collected $1.00 net credit.
  • Max profit is $1.00 at all prices over $105

As you can see from the scenarios above, using credit put spreads works in your favor when you expect the stock price to rise.  Ideally, a move above the upper strike of your options sold is ideal in order to collect full premium. 

 

Credit Call Spreads

 

A credit call spread is an alternative to an uncovered or naked call option.

The sale of an uncovered call option is a bearish trade that can be used when you expect the underlying stock to move downward.  

The goal?  To generate income when the naked call option is sold and wait for it to expire worthless.

When you place a bear credit call spread, the premium collected from the short position is offset from the purchase of long option position.  

As a result, you will generate income when the position is established, but will collect less than a naked call.  

One main benefit is that you don’t have unlimited risk on your trade.

 

Credit call spread example:

 

Buy 1 XYZ June 80 calls at $0.50

Sell 1 XYZ June 75 calls at $2.00

Net credit for $1.50

This spread is executed for a net credit of $1.50.

In this trade, you will profit if the market price of XYZ closes below $76.50 at expiration.

You will maximize your profit at or below $75.

You will lose money if the price of XYZ goes above the breakeven price of $76.50.

Max risk is a result of XYZ closing above $80 at expiration for $3.50

If you had sold the June 75 calls uncovered, you would have collected an extra $50 profit potential but would have had unlimited risk to upside stock movements.

 

How credit call spreads work

Scenario 1 : The stock rises significantly and closes at $90

 

In this scenario:

  • You will exercise your 80 calls and get assigned 100 shares of XYZ
  • Your 75 calls will be assigned requiring you to sell 100 shares of XYZ
  • Difference between buy and sell is a loss of $5.00
  • Net credit $1.50
  • Total loss $3.50

Scenario 2 : The stock rises slightly and closes at $78

 

In this scenario:

  • You won’t exercise your 80 calls because they are out of the money
  • Short 75 calls will be assigned, requiring to short 100 shares of XYZ 
  • Close out position by purchasing 100 shares of XYZ at market price 
  • Difference between purchase and sale price is $3.00
  • Net credit $1.50 when established
  • Total loss is $1.50, or $3.00-$1.50

Scenario 3 : The stock closes exactly at $76.50

 

In this scenario:

  • Will not exercise 80 calls because they are out of money
  • 75 short calls are assigned, requiring to sell short 100 shares of XYZ
  • Close out short position by purchasing 100 shares of XYZ at 76.50
  • Difference between spread is $1.50
  • Net credit $1.50 when established
  • Total loss is $0, or $1.50-$1.50

Scenario 4 : Stop drops and closes at $76

 

In this scenario:

  • You won’t exercise your 80 calls since they are out of the money
  • The short 75 calls will be assigned and you will be required to sell 100 shares of XYZ stock at $75
  • Close out of position by purchasing 100 shares at $76
  • Loss on spread of $1.00
  • Net credit : $1.50
  • Net gain of $0.50

Scenario 5 : Drops substantially and closes at $73

 

In this scenario:

  • You won’t exercise your 80 calls since they are out of the money
  • 75 calls won’t be assigned since they are out of money
  • All options expire worthless, no stock bought or sold
  • Max profit of $1.50 seen below $75

So, as you can tell from these scenarios, using credit spreads work to your advantage 90% of the time when the stock is expected to stay neutral or turn bearish.  

 

Wrapping up

 

For the most part, if a trader wants to collect income from naked options there is only a small advantage when doing so.

For the most part, when trading a credit spread, a trader is able to receive 90% of the same benefits as a naked options trader, but eliminates blowout risk in the event of a massive price move in the underlying stock. 

 

Advantages of credit spreads

 

  • Spreads can lower your risk substantially
  • The margin requirement for credit spreads are substantially lower than uncovered options
  • Not possible to lose more money than margin requirement held in account.  
  • Credit spreads require less monitoring than some other types of strategies. 
  • Spreads are extremely versatile due to the range of strike prices and expirations that are available for the trader to select.  
  • Little to no monitoring of position required, as typically wait for expiration to close trade.

Disadvantages of credit spreads

 

  • Your profit potential will be reduced by the amount spent on the long (covered) leg of the spread
  • Spread trading carries risk of being filled on the short option only, leaving you with an uncovered position.  

Want to know how it works with real money?

Click here to find out.

 

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