Back to Basics Friday: Credit Spreads For Quick Cash

As an investor, would you like to know you profit potential AND exactly how much money would risk on each trade?

If you answered yes, credit spreads are for you!

In very fancy words, spreads are a useful risk management tool for traders, but they are also a very predictable way to generate income.

When you trade a credit spread, you give up a limited amount of profit for the ability to limit risk.

Naked options can have substantial risk or even unlimited risk but also have the unlimited profit potential.

It’s a give and take.



It was explained as a bird in hand is worth two in the bush.

If you are content generating that income, regularly, then I will help you understand some more about credit spreads that you might find useful.

Here are 2 different credit spread strategies to consider.

1: Credit put spread. (Also referred to as a Bull Put Spread)

This is a bullish position that comes with more premium on the short put.

2. Credit call spread. (Also referred to as a

This is a bearish position that comes with more premium on the short call.

Credit Put Spreads

A credit put spread involves being short a put option and long another put option with the exact same expiration but a lower strike.  The short put is intended to generate income, while the long put’s objective is to offset the risk of assignment.  This protects the investor in the case of a sharp downward move.

Because of the relationship between the two strike prices, the investor will receive the premium when initiating this strategy.

If the investor gets the forecast wrong and the stock declines, the strategy leaves the investor with either a lower profit or in some cases a loss.  The total maximum loss is contained (capped) by the long put.

Here is a chart illustrating a Credit Put Spread (Bull Put Spread)

credit_put_spread.png

A Working Example of a Credit Put Spread

Buy 10 XYZ Jan 65 Puts @ .50

Sell 10 XYZ Jan 70 Puts @ 2 for a net credit of $1.50

The spread is executed for a net credit of $1.50 ($2 – $.5)

You will profit if the stock closes above $68.50 at expiration.

You will maximize your profit ($1,500) at any price north of $70.

You will lose money should XYZ close below $68.50, and you could potentially lose $3,500 if XYZ closes below $65 before or at expiration.

The 3 keys to remember when trading credit put spreads.

  • This is a credit spread where you collect money at the beginning of a trade.
  • It offers both limited risk and limited upside.
  • It is used to generate income and take advantage of volatility.

Credit Call Spread (Bear Call Spread)

A credit call spread is a vertical spread.  It contains two calls with the same expiration and different strikes.  The strike price of the short call is below the strike price of the long call, which allows this strategy to generate cash flow at the beginning of the trade.

The short call is placed to generate income, and the long call helps limit overall risk.

The profit potential of this strategy depends solely on the how much premium is retained before the strategy is closed out.  As the name suggests, it does best if the stock itself stays below the lower strike price for the duration of the trade.

However, an unexpected rally should cause a panic because when there is a limitation of profit, you are also able to minimize your loss.



credit-call-spread.png

A Working Example of a Credit Put Spread

Buy 10 XYZ Jan 80 Calls @ .50

Sell 10 XYZ Jan 75 Calls @ 2 for a net credit of $1.50

The spread is executed for a net credit of $1.50 ($2 – $.5)

You will profit if the stock closes below $76.50 at expiration.

You will maximize your profit ($1,500) at any price south of $75.

You will lose money should XYZ close above $76.50, and you could potentially lose $3,500 if XYZ closes at or above $80 before or at expiration.

The 3 keys to remember when trading credit put spreads.

  • This is a credit spread where you collect money at the beginning of a trade.
  • It offers both limited risk and limited upside.
  • It is used to generate income and take advantage of volatility.

Key advantages to trading credit spreads.

  • Spreads lower your risk if the stock moves drastically against you.
  • The margin for credit spreads is much lower than for naked options
  • It is impossible for you to lose more money than the margin requirement held in your account at the time the position was initiated.
  • Both debit and credit spreads require less monitoring than most other strategies because they are often held until expiration.
  • Spreads are versatile.

Key disadvantages to trading credit spreads

  • Reduced profit potential
  • Commission costs are higher because you need to open multiple trades.



— The Option Specialist

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About the Author: The Option Specialist