A credit spread is an option spread strategy where an investor sells options that have higher premiums than options that he buys; therefore, the investor enters the trade with a net credit.
This strategy is useful to investors as it allows them to profit from the buying and selling of options. In this article, investors will gain a basic understanding of the different types of credit spreads.
Bull credit spreads are used when an investor expects the underlying stock’s price to increase. An example of a bull credit spread is a bull put spread.
In a bull put spread, an investor sells an “in-the-money” put option while buying an “out-of-the-money” put option. By doing this, the investor receives a net credit entering the trade.
While using a bull put spread, the investor expects the stock’s price to rise and force both options to expire worthless. If this happens, the investor walks away with the net credit received when entering the trade.
Alternatively, if an investor expects the underlying stock’s price to decrease, then he could use a bear credit spread. An example of this is a bear call spread.
In a bear call spread, an investor sells an “in-the-money” call option while buying an “out-of-the-money” call option. With these transactions, the investor enters the trade with a net credit.
While using the bear call spread, an investor is expecting the underlying stock’s price to decrease. If this happens, the call options would expire worthless and the investor will keep the net credit he received when entering the trade.
Credit spreads can also be used by investors when they are neither bullish nor bearish on a stock.
If an investor expects a stock’s price to be very volatile in the near future, then he can implement credit spreads such as a short butterfly or a short condor.
In a short butterfly, an investor buys two “at-the-money” call options while selling an “in-the-money” call option and selling an “out-of-the-money” call option. By doing this, the investor enters the trade with a net credit.
In a short condor, an investor buys one “in-the-money” call option and one “out-of-the-money” call option while selling one “in-the-money” call option and one “out-of-the-money” call option. From this, the investor receives a net credit when entering the trade.
If an investor expects a stock’s price to remain relatively constant in the near future, then he can implement credit spreads such as an iron condor or iron butterfly.
In an iron condor, an investor sells one “out-of-the-money” put option and one “out-of-the-money” call option while buying one “out-of-the-money” put option and one “out-of-the-money” call option. This results in a net credit entering the trade for the investor.
In an iron butterfly, an investor sells one “at-the-money” put option and one “at-the-money” call option while buying one “out-of-the-money” put option and one “out-of-the-money” call option. The investor enters the trade with a net credit from these transactions.
These are all examples of certain credit spreads that could be used by investors to enter trades with a net credit. Investors should research each credit spread specifically to see how to best implement that strategy to generate profits.
