Credit Spreads:
A credit spread is implemented by simultaneously buying and selling options at two strike prices resulting in a credit to the investor. The investor is trying to sell the more expensive option and finance the purchase of the less expensive option by using part of the proceeds from the sale.
Let’s say the stock of ZUY is trading at $10. The $15 strike price call is priced at $3.00 and the $20 strike price call is priced at $1.00. If the investor sells the $15 strike price call at $3.00 and buys the $20 strike call for $1.00, the investor’s account is credited $2.00 per contract? (A call option consists of a contract for 100 shares of stock.) If the investor sells 10 contracts (buys 10 calls with strike price of 20 and sells 10 calls with strike price of 15),, he is credited with $2000 in his account (each contract being for 100 shares of stock). The risk of the trade is the difference between the two strike prices multiplied by the number of contracts multiplied by 100 less the credit received. For this example –
Strike price difference is $5, i.e., $20 – $15 = $5
Number of contracts 10 (each contract controlling 100 shares of stock)
Risk = $5 * 10 *(100) = $5000
Total Risk = $5000 – $2000 (credit received) = $3000
Technically no matter what happens to this trade the investor cannot lose more than $3000.
Please note the credit spread can be constructed for either Calls or Puts.
A call credit spread established at the top of the prevailing price of the instrument of choice is called a Bear Call Spread because we do not want the stock or index to breach the short (sold) call of the spread, i.e. in this example, we do not want the stock to go above $15 – the strike price of our sold calls. The Put credit spread established at the lower price range of the prevailing price is called a Bull Put spread, so named because the desired outcome is that the stock or index of choice does not fall
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