Reducing Risk with a Credit Spread Options Strategy

Would you like to determine your profit potential and approximately how much money you're risking before placing an options trade? If so, credit spreads may be for you.

Credit spreads are an options strategy where you simultaneously buy and sell options that are of the:

• Same class (puts or calls)
• Same expiration date
• But with different strike prices

Credit spreads have several useful characteristics. As mentioned, they can be a helpful risk-management tool for you. Credit spreads allow you to reduce risk substantially by forgoing a limited amount of profit potential. In most cases, you can calculate the exact amount of money that you’re risking when you enter the position.

Credit spreads are also versatile. You can find a combination of contracts to take a bullish or bearish position on a stock by establishing either a:

• Credit put spread: A bullish position with more premium on the short put
• Credit call spread: A bearish position with more premium on the short call  

Let’s discuss each strategy in more detail.  

Credit put spreads

A credit put spread can be used in place of an outright sale of uncovered put options.

The sale of an uncovered put option is a bullish trade that can be used when you expect an underlying security or index to move upward. The goal usually is to generate income when the uncovered put option is sold, and then to wait until the option expires worthless. Although the downside risk of uncovered puts is not quite unlimited, it is substantial, because you could lose money until the stock drops all the way to zero.

Credit spreads involve the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying security. In the case of a vertical credit put spread, the expiration month is the same, but the strike price will be different.

When you establish a bullish position using a credit put spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position. Let's look at an example.

Credit put spread example:

• Buy 10 XYZ May 65 puts @ .50
• Sell 10 XYZ May 70 puts @ 2 for a net credit of 1.50

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes above $68.50 at expiration. You will maximize your profit ($1,500) at $70 or above.

You will lose money if the price of XYZ goes below $68.50, and you could lose up to $3,500 if XYZ closes at $65 or below, at expiration. (Trade fees, taxes, and transaction costs, which are not included in this example, can affect the final outcome and should be considered. For the tax implications involved in these strategies, please speak with a tax advisor.)

Credit Put Spread

Source: Schwab Center for Financial Research.

If you had sold the May 70 puts uncovered, you initially would have brought in $2,000, rather than $1,500. However, the trade-off for reduced $500 profit potential is the ability to limit risk significantly. If you simply sold the May 70 puts uncovered, your loss potential essentially would have been $68,000 ($70,000 loss on the stock, less $2,000 premium received on the sale of the puts) if XYZ were to drop all the way to zero.

In the case of this credit spread, your maximum loss will generally not exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit put spreads work

To better understand the profit and loss characteristics of credit put spreads, let's examine five different price scenarios, based on the chart above. We'll assume that once this spread is established, it's held until expiration. (Reminder: trade fees, taxes, and transaction costs are not included in these scenarios.) 

Scenario 1: The stock drops significantly and closes at $62 on option expiration 

• If this happens, you will exercise your 65 puts, and sell short 1,000 shares of XYZ stock for $65,000.
• At the same time, your short 70 puts will be assigned, and you will be required to buy back your short position for $70,000 to close.

The difference between your buy and sell price is -$5,000. However, because you brought in $1,500 when the spread was established, your net loss is only $3,500. This will be the case at any price below $65. Therefore, this spread is only advantageous over uncovered puts if XYZ drops below $64.50.

Scenario 2: The stock drops only slightly and closes at $67 on option expiration 

• If this happens, you won't exercise your 65 puts, because they're out of the money.
• However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000.
• You can then sell your shares at the market price of $67, for $67,000.

The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500, at prices from $68.50 down to $65.

Scenario 3: The stock closes at exactly $68.50 on option expiration 

• If this happens, you will not exercise your 65 puts, because they're out of the money.
• However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000.
• You can then sell your shares at the market price of $68.50, for $68,500.

The difference between your buy and sell price results in a loss of $1,500. However, since you brought in $1,500 when the spread was established, your net loss is zero.

Scenario 4: The stock rises only slightly and closes at $69 on option expiration 

• If this happens, you won't exercise your 65 puts, because they're out of the money.
• However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000.
• You can then sell your shares at the market price of $69 for $69,000.

The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, your net gain is $500. This gain will vary from zero to $1,500, at prices from $68.50 up to $70.

Scenario 5: The stock rises substantially and closes at $72 on option expiration 

• If this happens, you won't exercise your 65 puts, because they are out of the money.
• Your short 70 puts won't be assigned, because they're out of the money as well.
• In this case, all the options expire worthless, and no stock is bought or sold.

However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices above $70.

As you can see from these scenarios, using credit put spreads works to your advantage when you expect the price of XYZ to rise, which will result in a narrowing of the spread price or, ideally, both options expiring worthless.

Credit call spreads

A credit call spread can be used in place of an outright sale of uncovered call options.

The sale of an uncovered call option is a bearish trade that can be used when you expect an underlying security or index to move downward. The goal usually is to generate income when the uncovered call option is sold, and then wait until the option expires worthless. When you establish a bearish position using a credit call spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position.

The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread, except the profit and loss regions are on opposite sides of the break-even point, as shown below. Let's look at an example.

Credit call spread example:

• Buy 10 XYZ May 80 calls @ .50
• Sell 10 XYZ May 75 calls @ 2 for a net credit of 1.50
   

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes below $76.50 at expiration. You will maximize your profit at or below $75.

You will lose money if the price of XYZ goes above $76.50, and you could lose up to $3,500 if XYZ closes at $80 or above at expiration.

Source: Schwab Center for Financial Research.

If you had sold the May 75 calls uncovered, you would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced $500 profit potential is the ability to limit risk significantly. If you had simply sold the May 75 calls uncovered, your loss potential would have been virtually unlimited if XYZ were to rise substantially.

In the case of this credit spread, your maximum loss will generally not exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit call spreads work

As we did with the credit put spread, let's examine five different price scenarios, in light of the chart above, to draw a clearer picture of how a credit call spread can work. We'll assume that once this spread is established, it's held until expiration.

Scenario 1: The stock rises significantly and closes at $83 on option expiration 

• If this happens, you will exercise your 80 calls and acquire 1,000 shares of XYZ at a cost of $80,000.
• At the same time, your short 75 calls will be assigned, and you'll be required to sell 1,000 shares of XYZ for $75,000.

The difference between your buy and sell price results in a loss of $5,000. However, you brought in $1,500 when the spread was established, so your net loss is only $3,500. This will be the case at any price above $80. Therefore, this spread is only advantageous over uncovered calls if XYZ rises above $80.50.

Scenario 2: The stock rises only slightly and closes at $78 on option expiration 

• If this happens, you won't exercise your 80 calls, because they're out of the money.
• However, your short 75 calls will be assigned, and you'll be required to sell short 1,000 shares of XYZ for $75,000.
• You can then close out your short position by purchasing 1,000 shares of XYZ at the market price of $78, at a cost of $78,000.

The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500, at prices from $76.50 up to $80.

Scenario 3: The stock closes at exactly $76.50 on option expiration. 

• If this happens, you won't exercise your 80 calls, because they're out of the money.
• However, your short 75 calls will be assigned, and you will be required to sell short 1,000 shares of XYZ for $75,000.
• You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,500.

The difference between your buy and sell price results in a loss of $1,500. However, because you brought in $1,500 initially when the spread was established, your net loss is zero.

Scenario 4: The stock drops only slightly and closes at $76 on option expiration 

• If this happens, you won't exercise your 80 calls, because they're out of the money.
• However, your short 75 calls will be assigned, and you'll be required to sell short 1,000 shares of XYZ for $75,000.
• You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,000.

The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, you have a net gain of $500. This gain will vary from zero to $1,500, at prices from $76.50 down to $75.

Scenario 5: The stock drops substantially and closes at $73 on option expiration. 

• If this happens, you won't exercise your 80 calls, because they are out of the money.
• Your short 75 calls won't be assigned, because they are out of the money as well.
• In this case, all the options expire worthless, and no stock is bought or sold.

However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices below $75.

As you can see from these scenarios, using credit call spreads works to your advantage when you expect the price of XYZ to fall, which would result in a narrowing of the spread price or, ideally, both options expiring worthless.

Before you consider the sale of uncovered calls or puts, consider the amount of risk you may be taking and how that risk could be significantly reduced by using credit spreads.

Advantages and disadvantages of spreads

To summarize, credit spreads have both advantages and disadvantages compared to selling uncovered options.

Advantages of credit spreads

• Spreads can lower your risk substantially if the stock moves dramatically against you.
• The margin requirement for credit spreads is substantially lower than for uncovered options.
• In most cases, you will not lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.
• Debit and credit spreads may require less monitoring than some other types of strategies because, once established, they're usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warranted. For example, if the underlying instrument moves far enough and quickly enough, you may be able to close out the spread position at a net profit prior to expiration.
• Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders can find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.
   

Disadvantages of credit spreads:

• Your profit potential will be reduced by the amount spent on the long option leg of the spread.
• Because a spread requires two options, the trade fee costs to establish and/or close out a credit spread will be higher than those for a single uncovered position.