The Credit Spread
The versatile credit spread is designed
to collect credit premiums when a stock moves
up, down or sideways.
Credit spreads are one of the most
powerful tools a trader has in his arsenal. Why?
Because it is rare for a stock to move only in
one direction, either up or down. It might move
up a couple days then down a couple days, but
overall if a stock moves up or down more than
20% in a year, it is a big event. Credit Spreads
allow you to take advantage of these market moves.
With a credit spread you can hedge
your downside risk by collecting credit premiums
on your trade regardless of market directional
movement. Let's see how.
What Is A Credit
A credit spread in a simple option
trade in which the trader sells one option and
buys another option farther away from the money.
This results in a credit to the trader. This credit
is the max amount that can be made on the trade
and is deposited into the traders account as soon
as the trade is made.
Example: XYZ stock is currently
trading at 100. A trader feels XYZ is a good candidate
for a Put Credit Spread. This trader think XYZ
is a great company and the stock is going to continue
its uptrend. So he sells one 90 strike Put, and
buys one 85 strike Put. The credit he receives
is 60 cents.
In this trade the highest premium
the trader can keep is 60 cents or $60 because
each option is made up of 100 shares. The most
the trader can lose is $440. This max loss is
also the margin requirement the broker will require
to be in the account to make the trade.
We can calculate the margin/ max
loss by subtracting the credit from the difference
between the strikes. In this case 90-85 = 5. So
$5 is the max loss per share. But the trader already
got paid .60 per share for the trade so the max
loss really is $4.40 per share or $440 per option
We calculate the return on our credit
spread options trade by dividing the potential
profit by the amount used for the trade. 60/440
= 13.6% potential return on this trade.
I trade Credit Spreads every
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had to. Find out more about becoming a member.
How the Credit
Spread Option Trade Makes Money
Ok so now we have the trade. But
how does it work?
Since we are short the 90 Put, we
want XYZ to stay above 90. If it is above 90 at
expiration (30 days in our example) then we get
the keep the whole credit. XYZ could go up or
it could stay around 100 or even down 10% and
the trade still makes money.
Even if XYZ goes below 90, as long
as it stays above our breakeven point of 89.40
we still make money.
In our example the trader thought
XYZ was not going to go down. But if he thought
instead that it was going to drop, he could have
done a Call Credit Spread using Call options instead.
The idea is the same except that he would not
want XYZ to rise above the strike of the call
option that he sold.
Since the credit spread is so easy
to trade, it can be done on any optionable stock,
ETF or index. The more volatile a stock the more
expensive the option and thus the more credit
you get. Also, the more expensive the stock, the
more expensive its options.
Many traders use technical analysis
to find trades. Find a stock in an uptrend and
sell Bull Put Credit Spreads month after month.
Or do the opposite. Find a stock in a downtrend
and sell Bear Call Credit Spreads
Other traders only trade their favorites.
So if you like trading a stock like Apple, you
can sell call spreads or put spreads depending
on what direction you think Apple is going to
move. And if you think Apple will just sit there
and do nothing, you can sell both a call spread
and a put spread at the same time. That is called
an Iron Condor and something I do on a monthly
basis - but not in Apple.
What's the Risk?
Does it sound too good to be true?
It's not, but there are risks involved. If you
look again at the example above we could make
$60 but also lose $440. If XYZ has bad news the
stock can drop. It has happened to every stock.
For this reason, credit spread trading is usually
reserved for the educated and trained trader.
So you have to protect yourself.
Notice that a credit spread is made up of two
options, one you sell and one you buy. If you
did not buy an option your position would be considered
naked and your risk could be unlimited. By buying
an option we start off by limiting the credit
Second, you must have proper money
management. If you have a $10,000 account, putting
it all in Put credit spreads on IBM would not
be a good idea. You need to spread your money
around so it is not at risk in the same trade,
in the same direction, or in the same month.
If you sign up for my FREE
Option Selling Course I will show you some examples
of Credit Spread trades I did and how I adjusted
them. To sign up just fill out your name and email
in the sign up form at the Top, Right of this
Third, you should know how to adjust
your position when it gets into trouble. This
is probably the most crucial part of the formula.
Anyone can put on a credit spread. But it takes
a real trader to know how to fix his trade when
it gets into trouble. By proper adjustments, you
can limit your loss, breakeven, or still make
money on a trade even if it goes against you.
Once you get a good handle on the
credit spread you can get into more complicated
option positions like the Iron Condor, the Butterfly,
and the Iron Butterfly. These positions are all
made up of credit spreads.
A great way to understand any trade
is to get experience trading it. That is why I
recommend paper trading to all my members. Paper
trading is always a good idea. When you get started,
don't just paper trade one spread, pick 20 stocks
and put on a trade in all of them. Keep records
about why you went with calls or puts and why
you chose the strikes you did. Eventually you
will see what works for you and you can develop
your own trading style.
Or you can join a service like mine
and see what spreads I am trading. You can see
how I choose my trades and how I manage them.
Trading along with a professional trader is the
best way I can think of to get started on the
Your Own Credit
With enough practice, experience,
and a proper trading plan you can actually turn
trading credit spreads into a business. Since
there are options for every month in the year,
you can just trade credit spreads month after