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Credit Spread
An option selling strategy where you sell an option
with a
higher premium and at the same time buy an
option with a lower premium of the
same underlying stock with the same expiration date.
The difference between these 2 premiums would be the maximum profit (known as a credit) you
could earn from this credit spread trade. The maximum risk of this trade would be the difference
between the strike prices of the 2 options minus the credit that you
have collected from the trade.
There are basically 2 types of Credit Spreads :
Bear Call Spread – a
bearish option selling strategy
For example, you sold a Sep 50 call on ABC for $4; and at the same time buy a Sep 55 call on ABC for $3. The credit of this spread trade
would be $1.00. If the stock price closes at $50 or less, both options
would expire worthless and you collect the $1.00 credit. Since each option contract is equivalent to 100 shares, the credit
that you collect would be $100.00 ($1 x 100).
You would normally enter a bear call spread if you are
bearish of the stock ABC and expect the stock price to drop and close at or below the strike price of the call option
that you've sold
(ie. $50), by expiration date. If the stock rises above the strike price of the call option
that you've you sold, it would be
advisable to close both positions (ie. the buy and sell to close
both positions) to cut loss since you might have anticipated the
direction of the stock price wrongly.
Bull Put Spread – a
bullish option selling strategy
For example, you might sell a Mar 110 put on XYZ for $4, and at the same time buy a Mar 100 put on XYZ for $1.50. The credit of this spread trade is $2.50. If the stock price closes at $110 or more, both options
would expire worthless and you would get to collect the $2.50 credit.
Once again, since each option contract is equivalent to 100 shares, the credit you
would collect from this Bull Put Spread would be $250 ($2.50 x 100)
You enter a bull put spread if you are bullish of the stock XYZ
and expect the share price to rise and close at or above the strike price of the put option you sold
(ie. $110), by expiration date. If the share falls below the strike price of the put option you sold, it
would be
again advisable to close both positions (ie. buy and sell to close both the put positions) to cut loss.
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