Credit Spread Option

Posted in Finance, Accounting and Economics Terms, Total Reads: 248
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Definition: Credit Spread Option

A credit spread option consists of the buying one option and selling another option in the same class but with different expiry dates and prices. There are two different benchmarks and when the difference expands or narrows, the investors receive profits. At the initial level, a premium is paid in order to obtain profits at later stages. The process consists of buying or selling call and put options.


Example:

An option is being sold which has the current market price and is expensive. Selling this option and buying the option forward creates a credit amount which serves as the premium. This amount is transferred to the trading account and at the end of the transaction, the total amount is the profit earned.


Types of Credit Spread:

1. Bull Put Spread- Buy a put and sell a put option also called Bullish Strategy

2. Bear Call Spread- Buy and sell a call option also called Bearish Strategy


Bullish Strategy:

When the trader expects a rise in the stock price, bull put spread is applied. A call option is bought with a low strike price and another call option is sold with a higher strike price. Both the options must have the same expiry date.

This will result in a credit spread because the amount received b selling a higher strike price option will give a profit which exceeds the price of buying the lower strike price put option.

Profit= (amount received for short put) - (amount used to pay for long put)


Bearish Strategy

Here, the trader sells call options at a specific strike price and buys the same number of calls at a higher strike price.

Profit= (price paid for long option) – (price gain on the short option)


Advantages:

• Credit spreads limit risk by reducing the loss by giving more profits

• They are versatile and the traders can use a combination of bearish and bullish strategies to obtain huge profits

• The risk can be quantified i.e. the trader knows the money he/ she is putting at risk

 

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