Credit Spread Option

The credit spread option is a popular option trading strategy that involves selling and buying options of a financial asset having the same expiration but different strike prices in such a way that it results in a net credit of premium when the strategy is being deployed with the expectation that the spread will narrow during the tenure of the strategy, resulting in a profit.

This options strategy limits the maximum loss while having the advantage of theta decay, thereby adopting the desirable characteristics of option buying and selling. By selling the option that has a higher price and buying the option with a lower price, the investor wants to earn a profit on the difference in premiums in case the option expires of its value falls.

• he credit spread option is a popular trading strategy. It involves buying and selling opportunities for the same asset, with different strike prices but the same expiration date. The goal is to earn a net premium credit by betting the spread will narrow during the strategy's duration.
• Bullish and bearish credit spreads are the two types of credit spread option strategies that depend on the underlying asset's view.
• This strategy adopts the favourable traits of buying and selling options while limiting the maximum loss and taking advantage of theta decay.

A credit spread option strategy is a kind of financial derivative that is a combination of options and credit derivatives. In this method, the investor purchases and sells options that have different strike prices but the expiration dates may be the same. This helps in creating a spread position.

Due to this spread, the investor is able to take advantage of the difference in premium and generate profits whereas at the same time, reduce risk of losses. Here, two options of same type and with same expiration dates are bought and sold, thereby transferring or mitigating the credit risk. Typically the investor sells an option that has a lower premium and also purchases an option that has a larger premium. The option with higher premium that is sold offsets the cost of purchasing the option that has less premium. The net credit is the gain for the investor.

This credit spread option strategy is frequently used by option traders who anticipate that the price of the underlying asset will remain stable to move in a particular direction. However, the process involves an element of risk along with return. If the underlying asset moves beyond the range of the spread, then there will be a significant loss.

There are primarily two types of Credit Spread Option strategy, which are used depending on what the view is on the underlying asset:

#1 - Bullish Credit Spread

This credit spread option trading is deployed when the underlying is expected to stay flat or bullish until the tenure of the strategy. This strategy involves selling PUTs of a particular strike price of the financial asset and buying PUTs (of equal numbers) of the lesser strike price.

#2 - Bearish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bearish until the tenure of the strategy. This involves call credit spread option  which is done by selling CALLs of a particular strike price of the financial asset and buying CALLs (of equal numbers) of the greater strike price.

#1 - Formula for Bullish Credit Spread

Where: X1 > X2

#2 - Formula for Bearish Credit Spread

Where: X1 < X2

Let us understand the concept of credit spread option trading with the help of some suitable examples.

Example #1

Let us take a listed company ABC whose stock is trading at $100 currently.

Following are the Strike Prices, and LTP (last trading price) of the immediate OTM (out of the money) calls.

• Strike Price = $105 | LTP = $5
• Strike Price = $110 | LTP = $4
• Strike Price = $115 | LTP = $2

Following are the Strike Prices and LTP (last trading price) of the immediate OTM (out of the money) puts

• Strike Price = $95 | LTP = $4
• Strike Price = $90 | LTP = $3
• Strike Price = $85 | LTP = $1

#1 - Bullish Credit Spread

From the given information, we can form 3 different bullish credit spread strategies:

1) Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $90

• = +$4 -$3 (Positive sign denoted inflow and Negative indicates outflow)
• = +$1 (As this is a positive quantity, this is net inflow or credit)

2) Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $85

• = +$4 -$1
• = +$3

3) Net Premium = Sell Put with Strike of $90 & Buy Put with Strike of $85

• = +$3 -$1
• = +$2

#2 - Bearish Credit Spread

From the given information, we can form 3 different bearish credit spread strategies:

1) Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $110

• = +$5 -$4 (Positive sign denoted inflow and Negative indicates outflow)
• = +$1 (As this is a positive quantity, this is net inflow or credit)

2) Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $115

• = +$5 -$2
• = +$3

3) Net Premium = Sell Call with Strike of $110 & Buy Call with Strike of $115

• = +$4 -$2
• = +$2

Example #2

Let us take an example of Apple Inc. stock and try to build a credit spread strategy and analyze the Profit and Loss.

At the end of the trading session on 18^th October 2019, the following was Apple's stock price.

The option chain of Apple for options contracts expiring on 25^th October is shown below.

The necessary data is now available for building this strategy.

• We would deploy a Bullish Credit Spread on Apple Inc. stock just a few minutes before the close of the market on 18^th October 2019.
• The two strikes chosen are $235 and $230. The Puts of each of these strikes have been highlighted. In this case, a $235 strike put will be sold, and the same quantity of $230 will be bought.
• The prices highlighted on the option chain will be used to build the payoff chart of the strategy.

The following result was obtained when the premiums of each of these strikes were fed into the option strategy builder. It can be seen that the strategy has a net credit of $1.12

Source: http://optioncreator.com

The following points are the highlights of the bullish credit spread on Apple Inc. stock.

• When held till the expiry, the maximum profit is $1.12, which is what is received at the time of deployment of the strategy.
• When held till the expiry, the maximum loss is $3.88
• The profit increases linearly as the stock price moves from $230 to $235, which are the two strikes chosen for this strategy.
• Below $230 & above $235 both the loss and gain are capped to $3.88 & $1.12 respectively.
• The risk-reward ratio is 1.12/3.88 = 0.29

To understand another dimension of this strategy, let us change the strike price of the put bought to $232.50. So, the $235 strike Puts will be sold, and the equal number of $232.50 strike puts that would be now used are:

The following result was obtained when the premiums of each of these strikes were fed into the option strategy builder. It can be seen that the strategy has a net credit of $0.73

It can be observed that:

• This pair of strikes' maximum gain and loss are $0.73 and $1.77, respectively.
• The risk-reward ratio is 0.73/1.77 = 0.41

As the strikes are changed to increase the credit spread, the risk/reward ratio from that strategy will get more skewed towards risk.

Let us understand the advantages of put or call credit spread option.

• This strategy is naturally hedged and limits the loss to a predetermined quantity, which can be calculated before the strategy is entered. (This phenomenon was observed in the above example of deploying bullish credit spread on Apple Inc. stock. The maximum loss was fixed and pre-calculated)
• Return on capital blocked as the margin is higher compared to naked option selling (as being spread strategy lesser margin is blocked)
• Time decay of option acts in favor of this strategy.
• Thus, if the market is range-bound, or relatively stable, the option will expire or the value will fall, due to which the trader can retain the initial credit.
• They have limited risk because the potential loss is already known upfront which gives the trader a clear idea about the risk level even before entering into the contracts.

The disadvantages of the process are as given below:

• The maximum profit is limited and obtained right at the time of deployment. Thus, along with limited credit spread option risk, the profit potential is also limited.
• The risk/reward ratio is skewed in favor of credit spread option risk. Since markets are unpredictable, it may also go against the anticipation of the trader. If the asset’s price goes beyond the credit range, loss may be high.
• There may be the requirement for a sufficient amount of margin for the trade, which also depends on the broker and the type of option.

Both the above terms are two different financial concepts that are frequently used by investors. However, let us try to identify the differences between them.

• The former is a financial derivative which is a combination of the options and credit derivatives whereas the latter is a measure that is used in amy fixed income instruments like bonds.
• In the former options with different strike prices are bought and sold, whereas for the latter, is a spread over a risk free rate that provides a compensation to investors for credit risk of a bond.
• The former takes advantage of differences in the premium of the two options which is not a part of z-spread.
• The former is calculated by finding the difference in premium whereas the latter is calculated by discounting the bond’s future cash flows using benchmark rates like treasury yields.
• The former is commonly used by option tradersand the latter is commonly used by fixed income investors.

Thus, the above are some of the differences between the above two financial concepts.

This has been a guide to What is Credit Spread options & their Definition. Here we discuss the formula to calculate the credit spread options example, along with types and practical examples. You can learn more about it from the following articles –

• Calculate Credit Spread
• Spread Betting
• Calculate Option Adjusted Spreads
• Call Options vs. Put Options