Credit Spread Trading Strategy: 2 Strategies You Need To Know

Would you like to learn how to generate consistent income while keeping your risk under control in the options trading market? If so, a credit spread trading strategy may be perfect for you.

A credit spread trading strategy involves simultaneously opening two opposite option positions (buy and sell) that are:

• From identical option types (calls or calls, puts or puts)
• Set to expire on the same date
• Choose different strike prices for each option

Credit spread trading strategies provide several compelling benefits. As you’ll discover, they offer an excellent balance of risk and reward. Credit spread trading strategies enable you to define your maximum loss while still capturing attractive premium income. You always know your maximum risk and reward before placing the trade, making it easier to plan effectively your options trades.

These options trading strategies are also quite flexible. You can structure your positions to profit from either bullish or bearish market moves by implementing either a:

• A bull put spread: Selling a put with a higher strike price
• A bear call spread: Selling a call with a lower strike price

Now, let’s dive deeper into how this credit spread trading strategy works in practice.

What is a Credit Spread Trading Strategy?

In options trading, a credit spread trading strategy (often called a “credit spread”) is a trade that involves selling one option and buying another option with a different strike price.

Essentially, by combining two options with the same expiration date, this strategy creates a net credit to your account at entry. By doing so, you collect a premium upfront, which represents the maximum potential profit from the trade.

This approach is designed to generate income while controlling risk. In this options trade setup, there is always a chance that the market moves against you, reducing the spread’s value and leading to potential losses. However, since the trade has a built-in risk limit, your losses are capped at a predefined amount.

When to use Credit Spread?

A credit spread trading strategy works well in different market conditions. Here are the best times to consider using a credit spread in your trades:

• Ranging Markets: Credit spreads are useful when you expect a stock to stay in consolidation. Since they can be designed to benefit from limited movement, they work well when prices aren’t trending strongly.
• Low Volatility: Credit spreads perform well when volatility is low because when prices are stable and not making big moves, time decay (theta) can work in your favor, helping you profit as option premiums decrease.
• Earnings Season: Traders often use them to take advantage of higher implied volatility before earnings, which tends to drop after the results are announced.
• Directional Uncertainty: If you’re unsure about where the market is headed, credit spreads can help. Since they can be structured with a neutral outlook, they allow you to profit as long as the market doesn’t make large moves.
• Income Generation: Selling options allows you to collect premiums, which can provide consistent cash flow, even when markets are quiet.

2 Credit Spread Trading Strategies

Here are 2 of the most common credit spread trading strategies:

Strategy #1: Bull Put Spread

A bull put spread consists of selling an in-the-money (ITM) put option and buying an out-of-the-money (OTM) put option with the same expiration date but a lower strike price. This options trading strategy is best used when the market is trending upward.

Example of a Bull Put Spread

Lisa wants to set up a bull put spread on XYZ stock. The stock is currently trading at $200. She sells an in-the-money put option for a $40 premium with a strike price of $220 that expires in March 2030. At the same time, she buys an out-of-the-money put option for a $15 premium with a $180 strike price and also expires in March 2030.

How much can she make or lose?

The net credit is $25 ($40 ITM put – $15 OTM put).

Using the standard formulas for this spread, Lisa calculates:

• Maximum profit = $25 (net premium received)
• Maximum loss = $220 – $180 – $25 = $15 (Short Put strike price – Long Put strike price – net premium received)
• Break-even point = $220 – $25 = $195 (Short Put strike price – Net premium received)

To verify, Lisa constructs the graph below:

Strategy #2: Bear Call Spread

A bear call spread is constructed by simultaneously selling a call option at a lower strike price and purchasing another call option at a higher strike price with identical expiration dates.

Example of a Bear Call Spread:

Imagine that XYZ Corp is trading at $50. You can create a bear call spread by buying a call option with a $60 strike price at a $1.00 premium ($1.00 × 100 shares/contract = $100 premium) and selling a call option with a $55 strike price at a $3.00 premium ($3.00 × 100 shares/contract = $300).

This gives you a net credit of $200 ($300 – $100) to open the trade).

Now, let’s break down the possible outcomes:

1. Stock price closes below $55: If XYZ Corp finishes below $55 at expiration, both options expire worthless, and you keep the $200 profit from the premium received.
2. Stock price closes between $55 and $60: If XYZ Corp ends between $55 and $60, the sold call option is exercised, and you must sell shares at $55. Since you don’t own the stock, you must buy shares at market value. Your loss is the difference between the market price and the strike price of the sold call, minus the $200 credit received.
3. Stock price closes above $60: If XYZ Corp finishes above $60, both options get exercised. You must sell shares at $55 (due to the short call) and repurchase at $60 (due to the long call). This results in a $500 loss, but the $200 credit reduces it, leaving a $300 maximum loss.

The breakeven point for this trade is $55 + $2 = $57, where $2 is the net credit received.

Here’s a summary of the outcomes:

• Maximum profit: $200 (net credit received)
• Maximum loss: $300 (difference between strike prices minus net credit)
• Breakeven point: $57 (strike price of sold call + net credit)

Now, if you have a moderate directional bias (up or down) we suggest checking out the debit spread trading strategy.