The credit spread is a very popular options strategy that, not only allows you to collect premium, but also limits your risk should the underlying do the opposite of what you thought it would.
There are 2 types of credit spreads: Short put verticals, and short call verticals. They are also called bull put verticals, and bear call verticals. I like short put and short call better, so that’s what I’m going to use for this article.
Short put verticals are used when someone is bullish on the underlying; they’re hoping to profit if the underlying stock rises in value. On the contrary, a short call vertical is used when someone is bearish on the underlying; they’re hoping to profit when the underlying stock declines in value.
The general idea is to sell the more expensive option, and buy the less expensive option (both within the same expiration). Selling the more expensive option nets you a premium – a credit that you receive in your trading account. Buying the less expensive option provides you with “insurance” that caps your maximum risk on the trade.
So how do you enter a short put or short call vertical? Let me tell you…
For my example, I am going to use a hypothetical stock, and the strike prices will be 100 and 105. And, of course, the same expiration date will be used when I enter this trade. The 100 strike will be $5 and the 105 strike will be $3. I will not include any brokerage fees either. And yes, you will have some kind of brokerage fee I’m sure. With that said, let’s begin!
I am bearish on stock ABC, and I decide I want to enter a short call spread to collect premium. Currently, ABC is trading for $100 per share. So, I pick the 100 strike to sell, and the 105 strike to buy. When I sell the 100 strike (at the money) I collect the $5 premium (credit) that this contract was selling for. I simultaneously purchase the 105 strike (further out of the money) for a $3 debit. Note: 1 option contract is 100 shares, so multiply the premium by 100 to determine actual total cost. In this case it would be $500 collected (credit), and $300 paid (debit)
The full credit I receive is the difference between the premium collected, and the premium paid. In this trade that is $2 per contract ($5 credit minus $3 debit). The $2 credit is deposited into my trading account ($200 total for the one contract). But, of course, before I entered this trade I determined what my risk vs. reward was. And because spreads are defined risk, it was easy to do so.
The maximum profit potential is the credit that I received. In this situation, that was $200 ($2 times 100 shares). The maximum risk potential is the spread width (distance between strikes) minus the credit received. In this situation, the strike width was $5 and the credit was $2, so my max risk potential is $300 ($3 difference times 100 shares).
ALWAYS determine risk BEFORE entering a trade. This should be your first step in deciding if the trade is worth it.
So, if ABC stays below $100 per share by expiration, I will keep the entire credit of $200. Remember, this credit was pretty much automatically deposited into my trading account when I placed the trade.
But what if ABC rises above $100 per share by expiration? Well, a couple things: 1) Break even or 2) lose your max risk… Remember that premium I collected? Well, to find the break-even price for ABC (the price in which you will not lose any money, nor will you keep your credited amount) you simply add the premium collected ($2 in this case) to the lower strike price ($100 in this case)… to break-even, I need ABC to stay below $102 per share ($100 strike plus $2 premium collected). Should ABC rise above $105 per share, I will lose my maximum risk of $300.
If ABC stays between $102 (break-even) and $105, you will get to keep some of the premium you collected, but not all of it.
And that’s really it. Pretty simple! But remember, I entered this short CALL spread because I was BEARISH on the underlying. If I was BULLISH on the underlying, I would have entered a short PUT spread. The short put spread is done the exact same way in reverse.
With a short put spread, you sell the higher strike and buy the lower strike. And, to determine the break-even, you subtract the premium received from the HIGHEST strike. If you recall, with a short call spread, you sell the lower strike and buy the higher strike. And, for break-even, you add the premium to the LOWEST strike.
It’s important to note that there are many different ways you can enter spreads. For instance, you can focus on in the money, at the money, or out of the money options. You can also widen the strike width beyond the 5 wide example I used.
Before you place your first vertical spread trade, you MUST understand them 100%. Even though they are defined risk, and your loss potential is capped, it is still a loss that can happen.