What is a Credit Spread?

A credit spread is a limited risk option strategy that involves buying and selling a call/put with the same expiration date but different strike prices. In the case of credit spreads, the short leg will have a higher premium than the long leg, resulting in a net credit paid to the investor. The maximum profit for this strategy is the net premium received when opening the trade. Credit spreads are ideal for scenarios where the investor has a neutral, moderately bullish, or moderately bearish view on a stock, ETF or index. There are 2 types of credit spread strategies that can be used:

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Example: Consider stock XYZ currently trading at $100

1. Bullish/neutral outlook - a bull put vertical spread can be used

• Sell $100 Put @ $4 Credit
• Buy $90 Put @ $1 Credit
• The maximum reward is the $3 income received. ($4 Credit -$1 Debit)
• The maximum risk is $7 (the difference between the 2 strike prices – premium received)

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For a bull put vertical spread, an “at-the-money” put is sold while an “out-of-the-money” put is bought. Even if there is a bullish outlook, selling a put alone has unlimited downside risk. By buying an “out-of-the-money” put, the net premium received is reduced from $4 to $3 but the risk is capped to the difference between the 2 strike prices minutes the premium received. At expiration, if XYZ is trading:

• Above $100 – Maximum profit of $3 
• At $97- Breakeven ($0 profit)
• Below $90 – Maximum loss of $7

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2. Bearish/neutral outlook – a bear call vertical spread can be used

• Sell $100 Call @ $4 Credit
• Buy $110 Call @ $1 Credit
• The maximum reward is the $3 income received. ($4 Credit -$1 Debit)
• The maximum risk is $7 (the difference between the 2 strike prices – premium received)

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For a bear call vertical spread, an “at-the-money” call is sold while an “out-of-the-money” call is bought. Even if there is a bearish outlook, selling a call alone has unlimited downside risk. By buying an “out-of-the-money” call, the net premium received is reduced from $4 to $3 but the risk is capped to the difference between the 2 strike prices minus the premium received. At expiration, if XYZ is trading:

• Below $100 – Maximum profit of $3 
• At $103- Breakeven ($0 profit)
• Above $110 – Maximum loss of $7

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Why use Credit Spreads?

Credit spreads tend to have a high probability of success due to this strategy being profitable even in neutral conditions. Whether the underlying makes a large move or stays neutral, the credit spread will still remain profitable and will need a significant adverse move to turn into a loss. However, there are two downsides to this strategy. The first being that credit spreads place a limit on the maximum gain. If the underlying rallies or declines significantly, the investor will not be able to take full advantage of the magnitude of the move. The other disadvantage to this strategy is that credit spreads have a negative risk/reward ratio – the maximum loss is higher than the maximum gain. Ultimately, credit spreads are a forgiving strategy that allows for income generation even if the underlying has a modest move in the opposite direction of the intended outlook. To maximize the use of credit spreads, they should only be used under certain market conditions. 

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When to use Credit Spreads

The most important guideline to remember about this strategy is that it should only be used during neutral market conditions or when there is a modest bullish or bearish sentiment. High volatility events such as earnings announcements should be avoided as there is a higher probability of the stock making a large move against the trade. Credit spreads are best utilized when the stock or ETF is trading in a range between a support and a resistance level. Overbought/oversold indicators or reversal chart patterns such as double tops/bottoms can be used as confirmation to enter a credit spread trade while the market is moving in a sideways range. 

Implied volatility is another important factor to consider before placing a credit spread. High volatility conditions increase an options price. This allows the investor to collect more premium when selling a credit spread. Collecting more premium improves the risk/reward of the trade provides an “edge”. The risk/reward relationship for a credit spread is determined by 2 factors – the premium received and the width of the spread. For a credit spread:

• Max Profit = premium received
• Max Risk = vertical width – premium received

Therefore, the higher the premium received, the lower the maximum loss for the trade will be. OptionsPlay’s Credit Spread Opportunity Report scans for credit spreads that meet multiple criteria - liquidity, price action, and premium received (>33% of vertical width). This provides an “edge” for investors looking to optimize their credit spread trades. 

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Optimal Credit Spreads

The key to finding the optimal credit spread is to find the right strike prices for your risk profile. Strike prices that are “near the money” allow for a better risk/reward ratio but have a lower probability of profit. Strike prices that are “far out of the money” have a high probability of profit at the expense of a worse risk/reward ratio. It may be tempting to use strike prices that are “far out of the money” that have a 90% probability of profit, however, our research shows that further out of the money strike prices do not generate enough income to account for when there is a big loss.

To find the ideal strike prices to use for credit spreads, stocks in the S&P 500 were analysed over a 10-year period. The outcome of this research showed that the most consistent strategy that yielded the best results over the long term met the following requirements:

• The options should have expirations between 4-6 weeks 
• Sell 50 Delta call/put
• Buy 25 Delta call/put

When using the above guidelines, the income received per trade is usually around 1/3 of the distance between the 2 strike prices. This equates to risking $200 for every $100 received and has a 60% to 70% probability of profit. Because credit spreads are a short Theta strategy, shorter expirations are used to maximize the use of time decay as weekly options are affected by Theta more than monthly options. 

OptionsPlay’s best practices to close out credit spreads are at:

• Take profits @ 50% of MAX GAIN
• Cut losses @ 100% of MAX GAIN
• Buy to close the credit spread at 21 days to expiration – this is to avoid Gamma risk where a small adverse move in the underlying asset’s price will result in a larger impact on the price of the option. 

For example: Sell a $10 wide credit spread for $4 (Max Profit)

• Take Profit - $2.00 Debit
• Stop Loss - $8.00 Debit

OptionsPlay’s Credit Spread Opportunity Report helps investors find optimal credit spread trade setups based on the above best practices and back testing results. Finding optimal credit spreads gives investors an edge on their trades that leads to long term profitability. The report ensures that only liquid symbols are taken into consideration and highlights important information such as the IV Rank, earnings date, and premium/width ratio. Updated every hour, this report scans for opportunities that yield a minimum premium of one third to that of the width of the vertical, giving investors a high probability of profit and increased income. To learn more about OptionsPlay’s Credit Spread Opportunity Report, watch this walkthrough.