## What is a Credit Spread Option?

Credit spread option is a popular option trading strategy which involves selling and buying options of financial asset having the same expiration but different strike prices in such a way that it results in a net credit of premium when strategy is being deployed with the expectation that the spread will narrow during the tenure of the strategy, resulting in a profit.

### Types of Credit Spread Option

There are primarily 2 types of Credit Spread Option strategy which are used depending on what the view is on the underlying asset:

#### #1 – Bullish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bullish until the tenure of the strategy. This strategy involves selling PUTs of a particular strike price of the financial asset and buying PUTs (of equal numbers) of the lesser strike price.

#### #2 – Bearish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bearish until the tenure of the strategy. This involves selling CALLs of a particular strike price of the financial asset and buying CALLs (of equal numbers) of the greater strike price.

### Credit Spread Option Formula

#### #1 – Formula for Bullish Credit Spread

**Net Premium Received = Premium Received while Selling PUT (of Strike X1) – Premium Paid while Buying PUT (of Strike X2)**

Where: X1 > X2

#### #2 – Formula for Bearish Credit Spread

**Net Premium Received = Premium Received while Selling CALL (of Strike X1) – Premium Paid while Buying CALL (of Strike X2)**

Where: X1 < X2

### Examples

Let us take a listed company ABC whose stock is trading at $100 currently.

Following are the Strike Prices and LTP (last trading price) of the immediate OTM (out of the money) calls

- Strike Price = $105 | LTP = $5
- Strike Price = $110 | LTP = $4
- Strike Price = $115 | LTP = $2

Following are the Strike Prices and LTP (last trading price) of the immediate OTM (out of the money) puts

- Strike Price = $95 | LTP = $4
- Strike Price = $90 | LTP = $3
- Strike Price = $85 | LTP = $1

#### #1 – Bullish Credit Spread

From the given information we can form 3 different bullish credit spread strategies:

1) Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $90

- = +$4 -$3 (Positive sign denoted inflow and Negative indicates outflow)
- = +$1 (As this is positive quantity this is net inflow or credit)

2) Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $85

- = +$4 -$1
- = +$3

3) Net Premium = Sell Put with Strike of $90 & Buy Put with Strike of $85

- = +$3 -$1
- = +$2

#### #2 – Bearish Credit Spread

From the given information we can form 3 different bearish credit spread strategies:

1) Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $110

- = +$5 -$4 (Positive sign denoted inflow and Negative indicates outflow)
- = +$1 (As this is positive quantity this is net inflow or credit)

2) Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $115

- = +$5 -$2
- = +$3

3) Net Premium = Sell Call with Strike of $110 & Buy Call with Strike of $115

- = +$4 -$2
- = +$2

### Practical Example

Let us take an example of Apple Inc. stock and try to build a credit spread strategy and also analyze the Profit and Loss.

At the end trading session on 18^{th} October 2019, the following was the stock price of Apple.

The option chain of Apple for options contracts expiring on 25^{th} October is shown below

The necessary data is now available for building this strategy.

- We would deploy a Bullish Credit Spread on Apple Inc. stock just a few minutes before the close of the market on 18
^{th}October 2019. - The two strikes chosen are $235 and $230. The Puts of each of these strikes have been highlighted. In this case, a $235 strike put will be sold and the same quantity of $230 will be bought.
- The prices highlighted on the option chain will be used to build the payoff chart of the strategy.

When the premiums of each of these strikes were fed in the option strategy builder the following result was obtained. It can be seen that the strategy has a net credit of $1.12

**Source:** http://optioncreator.com

The following points are the highlights of bullish credit spread on Apple Inc. stock

- When held till the expiry the maximum profit is $1.12, which is what is received at the time of deployment of the strategy.
- When held till the expiry the maximum loss is $3.88
- The profit increases linearly as the stock price moves from $230 to $235, which are the two strikes chosen for this strategy.
- Below $230 & above $235 both the loss and gain are capped to $3.88 & $1.12 respectively.
- The risk-reward ratio is 1.12/3.88 = 0.29

In order to understand another dimension of this strategy let us change the strike price of put that was bought to $232.50. So, the $235 strike Puts will be sold and the equal number of $232.50 strike puts that would be now used are:

When the premiums of each of these strikes were fed in the option strategy builder the following result was obtained. It can be seen that the strategy has a net credit of $0.73

It can be observed that:

- The maximum gain and loss for this pair of strikes are $0.73 and $1.77 respectively.
- The risk-reward ratio is 0.73/1.77 = 0.41

It can be observed that as the strikes are changed to increase the credit spread the risk/reward ratio from that strategy will get more skewed towards risk.

### Advantages

- This strategy is naturally hedged and limits the loss to a certain pre-defined quantity which can be calculated before the strategy is entered. (This phenomenon was observed in both the above example of deploying bullish credit spread on Apple Inc. stock the maximum loss was fixed and pre-calculated)
- Return on capital blocked as the margin is higher compared to naked option selling (as being spread strategy lesser margin is blocked)
- Time decay of option acts in favor of this strategy

**Disadvantages**

- The maximum profit is limited and it is obtained right at the time of deployment.
- The risk/reward ratio is skewed in favor of risk

### Conclusion

This options strategy limits the maximum loss while having the advantage of theta decay thereby adopting the desirable characteristics of option buying and selling respectively.

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