Credit Spread Option

Updated on April 11, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Credit Spread Option?

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

Credit Spread Option

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This options strategy limits the maximum loss while having the advantage of theta decay, thereby adopting the desirable characteristics of option buying and selling. By selling the option that has a higher price and buying the option with a lower price, the investor wants to earn a profit on the difference in premiums in case the option expires of its value falls.

Key Takeaways

  • he credit spread option is a popular trading strategy. It involves buying and selling opportunities for the same asset, with different strike prices but the same expiration date. The goal is to earn a net premium credit by betting the spread will narrow during the strategy’s duration.
  • Bullish and bearish credit spreads are the two types of credit spread option strategies that depend on the underlying asset’s view.
  • This strategy adopts the favourable traits of buying and selling options while limiting the maximum loss and taking advantage of theta decay.

Credit Spread Option Explained

A credit spread option strategy is a kind of financial derivative that is a combination of options and credit derivatives. In this method, the investor purchases and sells options that have different strike prices but the expiration dates may be the same. This helps in creating a spread position.

Due to this spread, the investor is able to take advantage of the difference in premium and generate profits whereas at the same time, reduce risk of losses. Here, two options of same type and with same expiration dates are bought and sold, thereby transferring or mitigating the credit risk. Typically the investor sells an option that has a lower premium and also purchases an option that has a larger premium. The option with higher premium that is sold offsets the cost of purchasing the option that has less premium. The net credit is the gain for the investor.

This credit spread option strategy is frequently used by option traders who anticipate that the price of the underlying asset will remain stable to move in a particular direction. However, the process involves an element of risk along with return. If the underlying asset moves beyond the range of the spread, then there will be a significant loss.

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Types

There are primarily two types of CreditTypes Of CreditTrade credit, bank credit, revolving credit, open credit, installment credit, mutual credit, and service credit are some of the different types of credit.read more Spread Option strategy, which are used depending on what the view is on the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more:

#1 – Bullish Credit Spread

This credit spread option trading 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 assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more and buying PUTs (of equal numbers) of the lesser strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

#2 – Bearish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more until the tenure of the strategy. This involves call credit spread option  which is done by 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

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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 understand the concept of credit spread option trading with the help of some suitable examples.

Example #1

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)OTM (out Of The Money)”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more 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 a 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 a 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

Example #2

Let us take an example of Apple Inc. stock and try to build a credit spread strategy and analyze the Profit and LossProfit And LossThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more.

At the end of the trading session on 18th October 2019, the following was Apple’s stock price.

Credit Spread Option Example 1

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

Credit Spread Option Example 1-1

The necessary data is now available for building this strategy.

Credit Spread Option Example 1-2

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

Credit Spread Option Example 1-3
Credit Spread Option Example 1-4
Credit Spread Option Example 1-5

Source: http://optioncreator.com

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

To understand another dimension of this strategy, let us change the strike price of the put 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:

Credit Spread Option Example 1-6

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

Credit Spread Option Example 1-7
Credit Spread Option Example 1-8
Credit Spread Option Example 1-9

It can be observed that:

  • This pair of strikes’ maximum gain and loss are $0.73 and $1.77, respectively.
  • The risk-reward ratio is 0.73/1.77 = 0.41

As the strikes are changed to increase the credit spread, the risk/reward ratio from that strategy will get more skewed towards risk.

Advantages

Let us understand the advantages of put or call credit spread option.

  • This strategy is naturally hedged and limits the loss to a predetermined quantity, which can be calculated before the strategy is entered. (This phenomenon was observed in 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.
  • Thus, if the market is range-bound, or relatively stable, the option will expire or the value will fall, due to which the trader can retain the initial credit.
  • They have limited risk because the potential loss is already known upfront which gives the trader a clear idea about the risk level even before entering into the contracts.

Disadvantages

The disadvantages of the process are as given below:

  • The maximum profit is limited and obtained right at the time of deployment. Thus, along with limited credit spread option risk, the profit potential is also limited.
  • The risk/reward ratio is skewed in favor of credit spread option risk. Since markets are unpredictable, it may also go against the anticipation of the trader. If the asset’s price goes beyond the credit range, loss may be high.
  • There may be the requirement for a sufficient amount of margin for the trade, which also depends on the broker and the type of option.

Credit Spread Options Vs Z- Spread

Both the above terms are two different financial concepts that are frequently used by investors. However, let us try to identify the differences between them.

  • The former is a financial derivative which is a combination of the options and credit derivatives whereas the latter is a measure that is used in amy fixed income instruments like bonds.
  • In the former options with different strike prices are bought and sold, whereas for the latter, is a spread over a risk free rate that provides a compensation to investors for credit risk of a bond.
  • The former takes advantage of differences in the premium of the two options which is not a part of z-spread.
  • The former is calculated by finding the difference in premium whereas the latter is calculated by discounting the bond’s future cash flows using benchmark rates like treasury yields.
  • The former is commonly used by option tradersand the latter is commonly used by fixed income investors.

Thus, the above are some of the differences between the above two financial concepts.

Frequently Asked Questions (FAQs)

What is the risk of the credit spread option?

In this technique, credit risk is effectively transferred from one party to another by swapping two options with the same class and expiration. In this case, there is a chance that the price of the specific credit will drop due to the spread becoming wider.

What is the credit spread option on the bond?

The yield differential between bonds with comparable maturities but differing credit ratings is a credit spread in the bond market. A bond’s yield is the return an investor will receive when it matures, but a bond’s credit rating indicates the risk of default for that specific bond.

What is the difference between a credit spread option and a vertical spread?

A long vertical spread is sometimes called a debit spread because the trader must pay to enter the deal. Since the trader earns a credit while initiating the sale, short vertical spreads are also known as credit spreads. There are specific profit-and-loss outcomes for every vertical spread.

Recommended Articles

This has been a guide to What is Credit Spread options & their Definition. Here we discuss the formula to calculate the credit spread options example, along with types and practical examples. You can learn more about it from the following articles –

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