If you’re looking for a way to profit in both neutral and directional markets, credit spread strategies might be exactly what you need. These options strategies, which involve the simultaneous purchase and sale of options contracts, are beginner-friendly and offer a balance of risk and reward. In this guide, we’ll see how using credit spreads—like a bull put spread or a bear call spread—can help you generate income while protecting your investments. Let’s learn how a credit spread option strategy can give you profits while protecting your investments.
Key takeaways
- A credit spread option strategy is an options trading strategy involving simultaneously buying and selling options contracts with different strike prices.
- There are two main types of credit spread option strategies: the Bear Call Spread Strategy and Bull Put Spread Strategy.
- In a bullish scenario, a Bull Put Spread Strategy can be one of the best risk-management techniques, while a Bear Call Spread Strategy can be beneficial in a bearish market.
Credit Spread Options for Beginners
A credit spread option strategy involves the simultaneous buying and selling of two options with different strike prices. This creates a net credit in your trading account, hence the term “credit spread trading.”
One of the main benefits of a credit spread option strategy is its limited risk. The maximum loss you could incur is restricted to the difference between the strike prices minus the net credit received. This makes credit spread options an attractive choice for beginners, as it helps manage potential losses while still offering a profit opportunity.
However, there are risks involved, too. If the underlying asset’s price moves significantly against your position, you could face losses. Also, the profit potential is limited to the net credit received. Hence, it’s crucial to understand these risks and manage your positions effectively.
Think of this as placing a bet on the Super Bowl. If you bet on two opposite events happening at two different moments in the game, you may reduce your risk (for instance, you may think that a team will score more in the first half, while the other team will lead at the end of the game).
Here is a quick look at the two strategies that we will analyze in today’s article:
| Strategy name | Market outlook | How to implement | Main benefits | Main drawback | Max profit potential | Max loss potential |
| Bear call spread | Neutral to bearish | Sell a lower strike call, buy a higher strike call | Limited risk and usually higher profit probability | Profit potential is capped | Net premium received | Difference in strike prices minus the premium received |
| Bull put spread | Neutral to bullish | Sell a higher strike put, buy a lower strike put | Limited risk and usually higher profit probability | Profit potential is capped | Net premium received | Difference in strike prices minus the premium received |
The Bear Call Spread Strategy
Let’s begin with analyzing the bear call spread strategy. This approach is a credit spread option strategy where you sell a lower strike call option and simultaneously buy a higher strike call option on the same underlying asset. This credit spread option strategy is implemented when you have a neutral to bearish outlook on the market.
To implement this, you first sell a call option with a lower strike price and collect a premium. Simultaneously, you buy a call option with a higher strike price. The premium from selling the lower strike call option offsets the cost of buying the higher strike call option, resulting in a net credit to your account.
A Typical Bear Call Option Spread Example
Now, let’s consider a real-life credit spread option example. Assume we have a bearish outlook on Stock XYZ, currently trading at $100. We could sell a call option with a strike price of $105 and collect a premium of $5. At the same time, we buy a call option with a strike price of $110 for a premium of $2. This results in a net credit of $3 ($5 – $2).
The potential outcomes of these bearish option strategies depend on the price of the stock at expiration. If Stock XYZ stays below $105, both options expire worthless, and we keep the net credit of $3 as profit. This scenario represents the maximum profit for the strategy.
However, if Stock XYZ rises above $105, the sold call option may be exercised. In this case, we would be obligated to sell Stock XYZ at $105. But remember, we also hold a call option with a strike price of $110. If the stock rises above $110, we can exercise this option to buy Stock XYZ at $110, limiting our losses. The maximum loss would be the difference between the two strike prices minus the net credit received, which would be $2 ($5 – $3).
The bear call spread strategy is an excellent example of how credit spread options for beginners can be used to generate income and manage risk. It’s a simple, straightforward credit spread option strategy that allows for a defined risk and profit potential. However, it’s essential to remember that market conditions can change rapidly, and it’s crucial to monitor your positions closely.
The Pros and Cons of Credit Spread Option Strategies
Credit spread option strategies offer a mix of advantages and challenges, making them suitable for traders with specific objectives. The table below sums up the main pros and cons of the credit spread option strategy:
| Pros | Cons |
| Limited risk | Limited profit potential |
| Income generation | Assignment risk |
Pros of Credit Spread Option Strategies
- Limited risk: A key advantage of the credit spread option strategy is its ability to limit risk. Your maximum loss is predefined, providing clarity and control in credit spread trading.
- Income generation: These strategies generate income as the premium received from selling a higher-premium option offsets the cost of buying a lower-premium option.
Cons of Credit Spread Option Strategies
- Limited profit potential: Credit spread trading caps profit at the difference between the strike prices minus the net premium received.
- Assignment risk: With credit spread options for beginners or seasoned traders, there’s a risk of being assigned the underlying stock if the spread isn’t closed before expiration.
Despite their limitations, credit spread option strategies—whether a bear call spread or bull put spread—can suit a range of market outlooks. For instance, a credit spread option example shows that even in a neutral market, traders can earn a profit without significant price movement.
A Real-Life Credit Spread Option Example of a Bear Call Spread (Credit Call Spread)
Let’s go into a practical credit spread option example using Advanced Micro Devices (AMD). Suppose you predict that AMD’s bullish streak, with the stock currently priced at $169.35, will soon take a break. To capitalize on this forecast, you might consider implementing a bear call spread, a type of credit spread option strategy.
If this is your belief, our options screener hints at the possibility of opening a bear call spread on AMD. You’d do this by purchasing a $190 call while simultaneously selling a $187.5 call. The goal here is for AMD to close below $188.43 by the expiration date of your call contracts to secure a profit.
But why choose this approach? If you examine AMD’s stock chart, you’ll notice that the stock failed to surpass this threshold a few weeks earlier. This resistance level provides an indication that AMD may struggle to break above this price point anytime soon. Also, consider that the profit probability for this operation is quite high, with a likely positive expected value. Keep in mind that if you ever happen to be wrong on this trading idea, you’ll face a limited loss with a profit ratio close to 67%.
This version of the credit spread option strategy is a good example of how credit spread trading can work effectively. By using the bear call spread strategy, you’re setting up a position that profits from a stagnant or slightly bearish market. It’s an excellent way to generate income in such market conditions, making it a valuable tool in any trader’s arsenal.
Remember, this credit spread option strategy isn’t without risks. If AMD’s stock unexpectedly surges past your sold call’s strike price, you could face losses. Therefore, it’s crucial always to monitor your positions and adjust them as necessary.
This real-life example highlights how credit spread options for beginners can provide an excellent way to profit in neutral or slightly bearish markets. We’ll tell you more about the main pros and cons of these trades later in the article. For now, just consider that this is a good way to make money in a neutral or slightly bearish market.
The Bull Put Spread Strategy
Another case that we recommend to explore is the Bull Put Spread strategy, a type of credit spread option strategy. In this credit spread option strategy, you buy a lower strike put option and simultaneously sell a higher strike put option. Let’s illustrate this with a classic example.
A Typical Bull Put Credit Spread Example
Suppose you’re neutral to bullish on XYZ stock, currently trading at $100. You decide to implement a Bull Put Spread strategy. To build this credit spread option strategy, you sell a put option with a strike price of $95 for a premium of $3 and buy a put option with a strike price of $90 for a premium of $1. This results in a net credit of $2 ($3 – $1) to your account.
The potential outcomes of this put options strategy depend on the price of XYZ stock at expiration. If XYZ’s price remains above $95 (the higher strike price), both options expire worthless, and you keep the net credit of $2 as profit. If XYZ’s price falls below $90 (the lower strike price), you’ll be obligated to buy the stock at $95 (due to the sold put) but can sell it at $90 (due to the bought put), resulting in a loss of $5 per share.
After considering the initial net credit of $2, your maximum loss would be $3 per share. If XYZ’s price ends up between the two strike prices at expiration, the sold put will be in-the-money, and you may have to buy the stock at $95. However, the bought put will expire worthless. With this credit spread option strategy, your overall profit or loss will depend on the exact ending price of the stock.
This credit spread option example illustrates how the Bull Put Spread strategy, a core part of credit spread options for beginners, can generate income while managing risk. The maximum profit is limited to the initial net credit received, and the maximum loss is capped, making this credit spread option strategy appealing for beginners.
However, like any other trading strategy, it’s crucial to understand that credit spread trading comes with potential outcomes and risks. The Bull Put Spread strategy is a tool that can be effectively used in bullish or neutral market scenarios. Remember to monitor your position closely to ensure it aligns with your market outlook and risk tolerance.
A Real-Life Example of a Bull Put Spread (Credit Put Spread)
Let’s examine Rambus (RMBS) and suppose you anticipate the current downtrend (with the stock at $56.25) nearing its end. In this situation, a credit spread option strategy known as a bull put spread might be your go-to move with RMBS.
Our options screener suggests buying a $45 put while selling a $50 put. This credit spread option strategy banks on RMBS staying above $49.35 by the time your puts expire to turn a profit.
If you observe RMBS’s price history, you’ll find it has hit this price level thrice in the past year, each time rebounding to higher levels. This pattern makes this credit spread option strategy particularly appealing.
This bull put spread is an example of credit spread trading, and it highlights why credit spread options for beginners are such an effective way to start exploring income-generating strategies. The goal is to capture the premium difference between the two, provided the stock price remains above the higher strike price at expiration.
This credit spread option strategy is ideal if you have a moderately bullish outlook on the stock. It allows you to profit from a flat or slightly rising market, making it a potent weapon for any trader’s arsenal.
However, it’s important to remember trading always involves risk. If RMBS’s stock unexpectedly dips below your sold put’s strike price, you will have to face losses.
This real-life credit spread option example demonstrates how beginners can utilize these strategies effectively, even when the market isn’t strongly bullish.
