Credit Spread Option Strategy Explained


The Credit Spread Option Strategy Explained

You have heard terms like passive income strategy, selling options and creating cash flow.

Most of these references are for option selling strategies which generate premium.

However, there are big dangers of using these strategies if you just fall for the allure of passive income.

More important than making money is preserving your capital.  My favorite quote (from myself) is that, “professionals manage risk, amateurs chase returns.”

In today’s article I will show you one of our favorite income plays, the credit spread option strategy.

I will share what it is, when it works, how to manage risk and much more.

Let’s get started.

 

Credit Spread Option Strategy: What is It?

The credit spread option strategy is a limited risk, limited return options trading strategy.

Credit spread option trades work best on stocks you expect to stay above, or below a certain level – for a certain period of time.

To build the bear call credit spread option strategy (term explained later) , a trader will:

  1. Sell a call option at a strike price of $X (collecting premium)
  2. Buy a call option at a higher strike price than $X (paying premium)

When the credit spread option strategy is netted out, you will be left with extra cash in your account.

That is, selling the closer strike call option will generate more cash for you than it will cost to buy the higher strike call.

If the option expires below the strike price you sold, you get to keep the full premium.

But at any rate, you will have to wait for the time to pass to realize that gain.

What happens if the stock shoots higher?

Your maximum loss is capped to the difference between the two strikes.

Limited risk makes this a favorite among professional options traders.

 

Credit Spread Option Strategy: How to Build One

First, let’s pull up an option chain of Apple stock.

If you want to learn more about option basics, check out our Foundations Course page here>

For the rest of this example, we are going to assume Apple is trading at $187.87 USD per share at this very moment.

Here is the Apple options chain with 17 days to expiry:

AAPL Credit Spread Option Strategy June Expiry

AAPL Credit Spread Option Strategy June Expiry

 

Now let’s imagine our technical analysis suggests Apple stock will remain below $192.50 for the next 17 days.

Looking at the middle column titled “strike”, you can see that $192.50 Call options with 17 days to expiry can be sold for $1.04 per contract.

That means you can collect $104 for each contract you sell.

In order to protect yourself however, you will use some of that $104 premium to buy a call option in the event you are wrong and the stock jumps up.

The $195 call option will cost you $57 per contract.

Netting the two would mean you keep $43 USD of cash in your account. ($104 – $57).  This amount is called the “credit”.  Hence the name, credit spread option strategy.

But when do you get to keep that cash flow?

 

Credit Spread Option Strategy: When Do You Profit and How Much?

Because you believe that Apple shares will stay below $192.50, you will profit if you are right with the credit spread option strategy.

How much do you keep?

Your maximum profit will be $43 USD per contract.  This will occur when Apple closes below $192.50 per share on the option expiry date.

That doesn’t sound like a lot, but you can scale to 10 contracts for a total of $430 USD in just 17 days.

To generate $430 USD using Apple, it would take a 10% move on the stock with 22 shares of ownership.

Credit spread option strategies help you capitalize on fixed income with fixed risk.

But when will you lose money, it sounds too good to be true right?

 

Credit Spread Option Strategy: When Do You Lose and How Much?

Obviously if the stock price goes higher in the next 17 days, you will start to lose money.

But how much?

The worst case scenario is if the stock jumps above $195 (the long call strike).

Why?

Because the long call option will start to offset the losses from the short call (that’s why we bought it).

Your maximum loss is the difference between the two strikes, minus the premium (called the credit) that you receive.

So $195 – $192.50 is $2.50 per share.

Each contract is for 100 shares, so this amount is $250.

Now subtract the $43 credit, and your maximum possible loss is $207.

But why would you risk $250 to make just $43?

In order to lose the maximum amount, Apple stock has to increase 2.5%.

If shares stay below $192.50 you win the full amount, which is a very high probability event for the next 17 days if your technical analysis is accurate.

Here is a chart below to help you visualize this credit spread option play:

  • highlighted zone is time until expiry (17 days)
  • Red represents where price would need to end up for partial or full loss
  • Green represents everywhere and below where you will realize full profit
Apple Credit Spread Option - Bear Call

Apple Credit Spread Option – Bear Call

Also, you can close the credit spread option strategy out at any point to minimize your losses.

Managing an open credit spread option is a more advanced topic taught in our options course part of the swing trader subscription package here >

Timing is key for the credit spread option strategy.

So when is the best time to sell call spreads?

 

Credit Spread Option Strategy: When Does it Work Best?

Credit spreads work best when you DO NOT expect a stock to get to a certain level.

Because the chances are 33% of a stock going anywhere, the probability you will be right is approximately 66%.

At any given moment, a stock can move up (33% chance), down (33% chance) or stay range bound (33%).

This strategy is very efficient at earning passive income, with a limited risk profile.

Another time that credit spread option trades work well are during times of increased volatility.

Why?

Because you will receive a juicier credit (premium for selling), but this is because there is an elevated chance of volatility and movement.

This means your chances of the stock moving to your loss is greater, so you are compensated more for selling the call spread.

 

Credit Spread Options Strategy: When to Avoid at All Costs!

You might be thinking, if volatility increases mean more money then I can sell credit spread options before earnings, right?

NO! I forbid you.

Earnings volatility ramps up because there is significant chances for a massive move against you.

The problem is that you cannot reasonably forecast the direction of an earnings move.

This type of speculation is called gambling. Be careful and avoid this rookie trap.

 

Credit Spread Option Strategy: Bear Call vs. Bull Put

The great news about credit spread options is that you can also sell put spreads and speculate that a stock will NOT drop.

Building this put spread is similar to the call spread.

The only difference is that you would use put options to create a credit premium.

I will provide you this caution however, stocks move to the downside much more rapidly (but less frequently).

This is why the premium tends to be wider and more lucrative to the downside.

 

Credit Spread Option Strategy: Income with Credit Spreads

In the video below our junior trader Victorio takes you through creating a credit spread and how to apply to your trading strategy.

Credit Spread Option Strategy: Conclusion

Using the credit spread option strategy in your trading is just one tool of many.

It is not a stand alone strategy that guarantees cash flows on a passive basis.

A lot of companies will market them that way, but it is very far from the truth.

We teach you how to trade options like a professional trader at an institution.

Let us show you the right way to build the credit spread option strategy and when to use it in more detail.

Checkout the swing trader package link below.

That’s it for today, thank you.

Manage that risk and trade like a TRADEPRO!

 

If you want to join us in our live trading room, check out the Day Trader package here >

If you prefer to trade more passively, checkout our newsletter, trade ideas and live analysis in the Swing Trader package here >


The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.