In finance, If there is an involvement of a purchase of one option and a sale of another option in the same class and expiration but different strike prices then it is referred to as a credit spread, or net credit spread. For entering the position investors receive a net credit, and they want the spreads to narrow or expire for profit. On the contrary, to enter a debit spread an investor would have to pay.
Credit Spread Options
A credit spread is used by a trader as a conservative strategy which is designed to earn modest income for the trader while also having losses strictly limited. Simultaneously buying and selling of (writing) options on the same security/index in the same month, but at different strike prices are involved in it. (This is also a vertical spread)
If the trader is BEARISH (expects prices to fall), then you have to use a bearish call spread. This name is given to it due to the reason that you’re buying and selling a call and taking a bearish position.
Let us consider the following.
Trader James expects XYZ to fall from its current price of $35 a share.
Write 10 January 36 calls at 1.10 $1100
Buy 10 January 37 calls at .75 ($ 750)
net credit $350
Now you should consider the following scenarios:
There is a fall in the stock or it remains below $36 by expiration. In this case all the options expire worthless and the trader has got the net credit of $350 minus commissions (probably about $20 on this transaction) netting approx profit of $330.
If there is a rise of above $37 in stock by expiration, you must need to unwind the position by buying the 36 calls back, and selling the 37 calls that have been bought by you; this difference will be $1, which is the difference in strike prices. For all the ten calls this costs you $1000; when the $350 credit is subtracted by you, then you will get a maximum loss of $650.
If the final price was between 36 and 37 then either your losses would be less or your gains would be less. $36.35 would be the “breakeven” stock price: this is the lower strike price in addition to the credit for the money you received up front.
Usually charting software and technical analysis are used by the traders to find stocks that are overbought(have run up in price and are likely to sell off a bit, or stagnate) as candidates for bearish call spreads.
If the trader is BULLISH, then you need to set up a bullish credit spread using puts. Let us consider the following example.
Trader Joe expects XYZ to rally sharply from its current price of $20 a share.
Write 10 January 19 puts at $0.75 $750
Buy 10 January 18 puts at $.40 ($400)
Breakeven
In order to find out the credit spread breakeven points for call spreads, we have to add the net premium to the lower strike price. For put spreads, to breakeven the net premium is subtracted from the higher strike price .
Most brokers will let allow you to engage in these limited risk / limited reward trades.
Maximum Potential
For call and put spreads, the maximum gain and loss potential are the same . Here you have to note down that net credit is equal to the difference in premiums.
net credit = the difference in premiums
Maximum Gain
Maximum gain is equal to net credit, they are realized when both options expire.
Maximum Loss
Maximum loss is equal to the difference in strike prices minus net credit.
Maximum loss = difference in strike prices – net credit.
Analysis
Credit spreads are considered as negative vega, if in case there is no change in price of the underlying, then the trader will tend to make money as volatility goes down. They are also negative rho in that, if in case there is no change in price of the underlying, then the trader will tend to make money just by the passage of time.
People who liked this Post also read
Posted by R. MAK. in Currency Rates, Currency Trade, Forex Basics, Forex Market, Forex trading, Trading · 0 Comment
