Disclaimer: This example is provided for educational purposes only. It is not intended to be any type of financial advice. For financial advice your should speak to a qualified Financial Advisor or Broker.
The Credit Spread is a positive geared cash flow strategy meaning that there’s no stock price movement required to receive our income.
It involves selling a Put in the case of a Bull Spread, or selling a Call in the case of a Bear Spread. For protection, a corresponding Put or Call is bought.
The following example shows the Bull Credit Spread. This strategy is used where you expect the stock to move up or go sideways.
There are two legs to a Bull Credit Spread ie a Short leg and a Long leg. The short leg is the Put Option that we SELL TO OPEN. It provides our income. The long leg is the Put Option we BUY as insurance to protect ourselves. It’s called a credit spread because the net of selling one option and buying the second is a net credit, or income.
In the example below we have Sold to Open (Short) the 975 Aug 99 Put 10 contracts for an income of $2,300 excluding brokerage. This gives us our income. To protect ourselves we have bought insurance by Buying to Open (Long) the 925 Aug 99 Put 10 contracts for a cost of $1,000 excluding brokerage.
So our net income is $1,300 excluding brokerage. You can see this in the Total column of the Select Positions section, and the Income of the Trade Analysis section.
Our at risk margin is $3,700, see Margin in the Trade Analysis section. This is calculated as follows…
The total of the spread is 50 cents multiplied by 10,000 = $5,000. The spread is the difference between the short option and the long option ie 9.75 – 9.25 = 50 cents multiplied by the number of options is 10,000.
This is our “maximum” exposure. But of course to offset this we have received some income ie $1,300. So our at risk margin is $5000 – $1300 = $3700. This is what we could lose if the stock fell below $9.25.
You can look at this in another way. If hypothetically the stock price ended at say $5.00 by expiry day, what would each option be worth. The Short one, the one we sold, has an exercise price of $9.75 that gives the holder the right to sell their shares to us for $9.75 even though they are worth only $5.00. So the real value of this option is around $4.75.
The Long option, the one we bought as insurance, gives us the right to buy shares at $9.25 even though they are only worth $5.00. So this option has a real value of around $4.25.
So if the stock ended at any price below $9.25, we would be forced to buy stock at $9.75 and we could then sell this stock at $9.25 ie a 50 cent loss.
Note: Your at risk margin can be slightly higher than this if the options go ITM prior to expiry. This is because the value of the short option may rise quicker that the value of the long option.
In the Trade Analysis we can see that the ROI is 35.1%. This is calculated by taking the income of $1,300 and dividing it by the margin $3,700. $3,700 being our maximum exposure, or in other words, cash we need at hand to cover this position.
Now let’s look at how the trade would have progressed. Below is how the trade has unfolded half way through the life of the options.
What we are looking for in a Bull Credit Spread is for the stock price to end ABOVE THE SHORT OPTION’S EXERCISE PRICE; in our example $9.75. If this happens, both options will expiry worthless and we keep all the income received and the whole trade expires.
However if the stock price end below the $9.62 breakeven point, we are in a loss position. There are some techniques to recover from this loss position that you should talk to your Broker about.
So the stock price in our example has fallen to the breakeven point, bounced off it and is now above the 925 exercise price. We are half way through this trade and the option values (see the Option Chart) are already decaying ie time is running out. Time in this case works in our favor.
Notice the Debit/Credit column in the Open Positions section. See how both options have decreased in value but that the Short position is a positive amount. This is because we are Short this position i.e. we sold it to open it. When using short positions we look to first SELL HIGH AND THEN BUY LOW ie the opposite to what we are used to of BUYING LOW AND SELLING HIGH.
So this is why as the value of the short position goes down, our profit goes up.
The $600 in this same column, indicates our income if we decided to close out both positions today ie our net position.
Now if we step forward to expiry we can see that the stock price has ended above the short strike price and so both options will expiry worthless, see below.
Next example we’ll review what happens if the stock price ends below the short strike price.