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How to Use a Credit Spread Options Strategy to Reduce Risk

Credit spreads may be ideal for you if you want to determine your profit potential and the approximate amount of money you’re risking before making an options trade.

A credit spread refers to the difference between the returns of two bonds with different credit potential but the same maturity rate. The strategy involves buying one option and selling a second similar option with a different strike price. The credit spread strategy can make a consistent return of up to 30% in each transaction. 

Understanding Credit Spread Strategy

Credit spreads can be classified into two types: bull put credit spread and bear call credit spread. Investing in a bull put credit spread strategy will allow the trader to anticipate that the stock prices will rise in the future. On the other hand, the call credit spread strategy enables the trader to profit if the stock market falls downward. The credit spread strategy can make a profit in both situations because the time decay is always in its favor. 

The spread is used to reflect the additional return by an investor for taking on additional credit risk. These strategies use the difference in yield between a corporate bond and a same-maturity bond. If the spread is higher, the corporate bond will be riskier. 

Example of Calculating a Credit Spread

The investor buys and sells two bonds, Bond A and Bond B. Bond A has a 10% and Bond B offers a 5% yield. These bonds have different credit ratings on the market, but their maturity dates are the same; hence, the credit spread is calculated as (10 percent – 5 percent) = 5%.

Bull Put Credit Spread Option Strategy

Put credit option is a bullish transaction that can be employed when the amount of the underlying security is expected to rise in value. Put spreads consist of selling a put option and purchasing another at a lower price. Both puts have the same common stock and expiration date. When the trader believes the cost of the underlying asset will be higher than the strike price of the short put option on or before the expiration date, they enter a bull put credit spread.

The strategy allows the trader to take advantage of a boost in price in the underlying investment before expiration. In addition, time decay and reduced implied volatility will also benefit the bull put credit spread.

A bull put spread is usually considered when the trader wants to earn premium income with a lower degree of risk involved in writing puts only. Additionally, this strategy is an excellent way to buy a stock at a lower price and generate income in a volatile market

Example of a Put Credit Spread

Stock XY is trading at $50.

  • Sell 48 put for $0.50
  • Buy 46 put for $0.20

The net credit that the trade would create is $0.30 ($30).  

Bear Call Credit Spread

A bear call spread option is a bearish strategy in which a call option is sold, and another is purchased at a higher price. The approach aims to profit from a price drop in the underlying asset before it expires. Time decay and decreased implied volatility will also assist the bear call credit spread.

When the trader expects the price of the underlying asset will be below the strike price of the short call option on or before the expiration date, they enter a bear call credit spread. The bear call credit spread’s break-even price is the short strike price plus the net credit received. 

The credit call spread is comparable to the credit put spread in many aspects. The main difference is that the profit and loss areas are on opposing sides of the break-even point. The main benefit of a bear call spread is reduced net risk of the trade. Purchasing the call option with the higher strike price helps neutralize the risk of selling the call option with the lower strike price.  

Example of Bear Call Credit Spread

The XY stock is trading at $45.

  • Purchase one call option at $40 and a premium of $0.50
  • Sell one call option at $30 for $2.50 

The net credit is $200 to set up this strategy ($250 – $50) 

Conclusion

Credit spreads can assist investors in anticipating market movements and preparing for a call or put credit spread. The credit spread entails purchasing and selling option contracts belonging to the same class but with varying credit capacities. So, investors must assess the market situation and the credit spread. Understanding the spreads of the underlying assets can give investors an idea of the bond’s return and a better sense of how much the market can change.

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