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Many traders are familiar with collecting premium by selling options, and it has proved to be a profitable strategy. However, the unlimited risk that comes with selling options has kept many on the sidelines, even if they have a strong option on where a market won’t go. Credit spreads offer you the ability to collect premium while having a defined risk.
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What is a credit spread?
A credit spread is the purchase of one option and the sale of another option in the same underlying futures market with the same expiration but at different strike prices. This is done by selling an option with a strike price closer to where the underlying market is trading and buying an option further away from where the underlying market is trading. Since you are selling an option closer to the money, it will have a higher premium associated with it than the further away option you are buying. The trader is collecting more premium than he is paying, resulting in a credit. This is why it is referred as a credit spread.
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The goal of the spread is to have both options expire worthless. This is when a trader will experience maximum profit and keep the entire premium collected. The risk on the spread is the difference between the two strike prices and calculated in actual futures prices (i.e. a 6.50/6.00 corn credit spread would have a max risk of $2500 ($50 for each cent move)).
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When is a credit spread appropriate?
A credit spread is appropriate when you think a market won’t trade to a certain level. If you have a bullish sentiment on a market, you would want to enter a put credit spread. If you have a bearish sentiment on a market, you would want to enter a call credit spread.
Example
Mark is a grains trader who has a bullish sentiment on the overall market due to his research in fundamental and technical analysis. He feels that the market will have a hard time breaking through the $6.50 level on December corn. He doesn’t want to use a futures position to go long due to the recent volatility that the market has seen. He decides a credit spread is his best option since his option is on where the market won’t go. He decides to take a look at what the premium is for the 6.50/6.00 December corn put credit spread.
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6.50 Put Premium: $1450
6.00 Put Premium: $450
Since he is selling the 6.50 put and buying the 6.00 put, he can collect $1000 for initiating the position – this will be his maximum profit on the trade and will be realized at expiration. The risk for the position is the difference in the strike prices, or $2500. Mark is comfortable with the risk and the reward on the trade so he initiates the position.
The day of expiration is now here and December corn is closes at $6.75 per bushel. The options expire worthless. Mark was correct in his analysis that the market would be above $6.50 when the options expire. The market did break below $6.50 at times, but Mark was comfortable with this because he was willing to assume the risk associated with the position when he decided to enter the market. This is key, as you should never enter a position if you aren’t comfortable with assuming the full risk associated with it.
Summary
Credit spreads are a great way to get involved in a market when you think it won’t trade to an area. The risk and reward characteristics are different from an outright futures position and purchasing options. However, if a trader is comfortable with the risks, credit spreads can be a great addition to a trader’s strategy.
STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.
