What is a credit spread?
Investopedia says… “An options strategy where a high premium option is sold and a low premium option is bought on the exact same underlying security.”
OK I know that is extremely vague, so lets see if I can do much better.
It is a trading technique in which you purchase an out of the money option at a certain strike price and then you sell an out of the funds choice at a diverse strike price of the same month. As time goes on the alternatives will decay in value and as lengthy as the price of the stock does not go past the sold strike price at the end of expiration you will obtain a full credit winning trade.
For example,it is January and XYZ stock is presently at and it looks as if it is bullish or will improve in price over the next month and you firmly believe that the stock will not go below . You would trade a Bull Put Credit Spread on a Feb expiration. You would buy the Feb 45 put for $ .25 and you would sell the Feb 50 put for .00. This leaves you with a credit of $ .75 in your account or really per contract you trade. The risk of the trade or the quantity of money per contract you need in your account is 5 per contract. This gives you a return on investment of 17.5% in how ever quite a few days till Feb expiration.
Lets take it out like a real trade – It is January 13 and Febuary expiration is in 35 days. You place the trade for 5 contracts. So you now acquire 5 FEB XYZ 45 PUTs for $ .25 or 5 total and you sell 5 FEB XYZ 50 PUTs for .00 or giving you a credit of 5 in your account. Now to back the trade up with collateral in case the trade goes wrong you will need to have 25 in your account for just this trade. If XYZ closes above in 35 days you will have received 5 which is a 17.6% gain. There is a break even cost of .25 that if the stock closes at this number you will neither gain or lose cash. If the stock closes between .25 and you will lose some cash and if it closes below you will lose 25.
If you like the notion of knowing exactly what your profit will be, exactly when the trade is closed, and precisely how much dollars you will risk then credit alternative spread trading is for you. Your profit margins will be between 10 and 20% on each trade – on some of the aggressive credit spreads you can make over 50% – and there are tactics for changing your trade if it becomes a losing trade to aid you recover some of the loss and in some instances even make it a winning trade once more even though you were wrong on the direction of the movement of the stock.