A credit spread involves purchase of one option (call or put) & the sale of another option, both with the same maturity and underlying security but with a different strike price. The main reason why this strategy is called a credit spread is because it involves net inflow of premium from the two positions involved in this strategy (for example, by selling a put with a higher premium and purchasing another put option with a lower premium).

The basic idea here is the transfer of credit risk from one party to another. This can be used as a risk management tool by option traders at the cost of giving up a limited amount of profit potential.

There are 2 types of credit spreads, differentiated based on whether the trader has a bullish or bearish stance on the underlying security. These are:

1. Credit put spread
2. Credit call spread

Credit put spread

Also known as the Bull put spread, this strategy involves the sale of a put option with a higher strike price (thus a higher option premium) and buying another option with a lower strike price (thus involves a lower option premium).

As the name suggests, one will use this strategy if he/she is of the opinion that the price of the underlying security will rise in future. The basic objective here is to take option positions in such a way so that both of them expire unexercised, leaving us the difference between the option premiums. Now we will look at an example to make things clear for you

Example:

Suppose I am bullish on a stock & the stock is trading at $40. To apply the strategy I will then sell a put option contract with a strike price of $45 for a cost of $4.75 and buy one put option contract with a strike price of $40 for $1.75, both for the same time period (let’s say a year). In this case, I will receive a total of $3 per share to set up this strategy ($4.75 – $1.75 i.e. $3). So now, what could be the possible cases that might arise at the end of the year?

Case 1: When the stock price is above the higher strike price

Let’s say that the stock price is $46. In such a case, we can’t exercise our put option thus we subtract 1.5 from our calculation of the final position. At the same time, the party which bought the option from us also won’t exercise the option thus we add 4.5 to the calculation which leaves us with a profit of $3.

Case 2: When the stock price is in between the higher & lower strike price.

Let’s say that the stock price at the end is $41. In such a case, the other person will exercise his option, leaving us a total of $0.5, after including option cost (i.e. $4.5 – $4). On the other hand, we won’t exercise the put option, thus subtracting $1.5. This leaves us with a loss of $1.

Case 3: When the stock price is below the lower strike price

Let’s say that the stock price is $39. In this case, the value that we derive from our short put position is -$1.5 (i.e. $4.5 – $6). Also, we lose $0.5 (i.e. $1 – $1.5) from our long put position. This leaves us with a loss of $2.

Credit Call Spread

Also known as the Bear Call Spread, this strategy involves the sale of a call option with a lower strike price (thus a higher option premium) and buying another option with a relatively higher strike price (thus involves a lower option premium). As the name suggests, one will use this strategy if he/she is of the opinion that the price of the underlying security will fall in future. The basic objective here is to take option positions in such a way so that both of them expire unexercised, leaving us the difference between the option premiums (per share). Again, we will look at an example to make things clear for you

Example:

Suppose I am bearish on a stock & the stock is trading at $40. To apply the strategy I will then sell a call option contract with a strike price of $40 for a cost of $4.75 and buy one call option contract with a strike price of $45 for $1.75, both for the same time period (let’s say a year). In this case, I will receive a total of $3 per share to set up this strategy ($4.75 – $1.75 i.e. $3). So now, what could be the possible cases that might arise at the end of the year?

Case 1: When the stock price is above the higher strike price

let’s say that the stock price is $47. In such a case, the other party will exercise its call option Thus we will have to subtract $2.5 from our final position (i.e. $4.5 – $7). Similarly we will also exercise our call option, leaving us with $0.5 from this position. (i.e. $2 – $1.5). Considering both the positions, we incur a loss of $2.

Case 2: When the stock price is in between the higher & lower strike price.

Let’s say that the stock price at the end of the period is $41. In such a case, the other person will exercise his option, leaving us a total of $3.5, after including option cost (i.e. $4.5 – $1). On the other hand, we won’t exercise the call option, thus subtracting $1.5 from the final value. This leaves us with a profit of $2.

Case 3: When the stock price is below the lower strike price.

Let’s say that the stock price is $39. In this case, the value that we derive from our short call position is $4.5. Also, we lose $1.5 from our long call position. This leaves us with a profit of $3.

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References:

1. https://www.investopedia.com/terms/c/credit-spread-option.asp
2. https://www.youtube.com/watch?v=sZrMhrmhDCQ