Credit Spread Option

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 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 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 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 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

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Credit Spread Option (wallstreetmojo.com)

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)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

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 18th October 2019, the following was the stock price of Apple.

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

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

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.

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:

Credit Spread Option Example 1-6

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

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

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.

Recommended Articles

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

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *