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Determining the potential profit and how much capital you are risking is certainly a good idea if you want to place an options trade. Credit spreads are an options strategy that helps do that.
In this spread options strategy, you simultaneously buy or sell options with the same class and expiration date but different strike prices. Understanding spread options trading can be challenging for some, but you can reduce the risks associated with such trading by using a credit spread strategy.
Credit Spreads Strategy Types and How They Work
Credit spreads help you mitigate risks by creating limited profit potential. Usually, you get to determine the exact amount of capital you risk while entering the position. You can take a bullish or bearish position on a stock by establishing one of the following credit spread strategies:
- Credit Put Spreads
A credit put spread is generally used instead of an outright sale of uncovered options. This is a bullish trade that you use when you expect an upward movement of the underlying security or index. This strategy aims to generate profit when the uncovered put option is sold. Then, you need to wait until the option loses all its value through expiration.
The downside risk of uncovered puts is not limitless since you could lose money until the stock becomes completely worthless. Credit spreads are all about the simultaneous buying and selling options contracts of the same class on the same underlying security. For a vertical credit put spread, the expiry month remains the same, but there will be a difference in strike price.
When you use a credit put spread to establish a bullish position, you pay a lower premium while purchasing an option than what you receive while selling that option. This allows you to generate profit once the position is established. However, the profit is still less than you would get with an uncovered position.
Using credit put spreads can work in your favor when you expect the price of a certain option to rise. This practice leads to either narrowing the spread price or both options losing their worth through expiration.
- Credit Call Spreads
The sale of an uncovered call option is generally a bearish transaction used when you expect the downward movement of an underlying security or index. The goal is to secure a profit after selling the uncovered call option. Then, you need to wait until the option loses its value through expiration.
When you use a credit call spread to establish a bearish position, you generally pay a lower premium to buy an option than you receive while selling that option. Thus, you can generate profit after establishing the position, but it would still be less than what you could generate with an uncovered position.
You can use credit call spreads in your favor when you expect the price of a certain option to fall. This would lead to the narrowing of the spread price or both options losing their worth through expiration.
Reasons to Use Credit Spread Options Strategy while Trading
There are a number of reasons why traders use credit spreads instead of selling uncovered options. Some of them are listed below:
- Spreads can significantly mitigate risks when the stock does not move as expected.
- The margin requirement is lower for credit spreads than for uncovered options.
- When establishing the position, you cannot lose more than the amount held in your account as the margin requirement.
- Debit and credit spreads usually require less monitoring when compared to other strategies. This is because they are generally held till expiration once established.
While a credit spread options strategy can significantly lower your trading risks, you still need to develop a thorough understanding of it before investing. Moreover, you must look at your investment goals and see whether these strategies fit them.