What is a Credit Spread Option?

Types of Credit Spread Option

There are primarily two types of CreditTypes Of CreditTrade credit, bank credit, revolving credit, open credit, installment credit, mutual credit, and service credit are some of the different types of credit.read more Spread Option strategy, which are used depending on what the view is on the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more:

#1 – Bullish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bullish until the tenure of the strategy. This strategy involves selling PUTs of a particular strike price of the financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more and buying PUTs (of equal numbers) of the lesser strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

#2 – Bearish Credit Spread

This strategy is deployed when the underlying is expected to stay flat or bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more until the tenure of the strategy. This involves selling CALLs of a particular strike price of the financial asset and buying CALLs (of equal numbers) of the greater strike price.

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Credit Spread Option Formula

#1 – Formula for Bullish Credit Spread

Where: X1 > X2

#2 – Formula for Bearish Credit Spread

Where: X1 < X2

Examples

Let us take a listed company ABC whose stock is trading at $100 currently.

Following are the Strike Prices, and LTP (last trading price) of the immediate OTM (out of the money)OTM (out Of The Money)”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more calls.

  • Strike Price = $105 | LTP = $5Strike Price = $110 | LTP = $4Strike Price = $115 | LTP = $2

Following are the Strike Prices and LTP (last trading price) of the immediate OTM (out of the money) puts

  • Strike Price = $95 | LTP = $4Strike Price = $90 | LTP = $3Strike Price = $85 | LTP = $1

From the given information, we can form 3 different bullish credit spread strategies:

  1. Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $90
  • = +$4 -$3 (Positive sign denoted inflow and Negative indicates outflow)= +$1 (As this is a positive quantity, this is net inflow or credit)
  1. Net Premium = Sell Put with Strike of $95 & Buy Put with Strike of $85
  • = +$4 -$1= +$3
  1. Net Premium = Sell Put with Strike of $90 & Buy Put with Strike of $85
  • = +$3 -$1= +$2

From the given information, we can form 3 different bearish credit spread strategies:

  1. Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $110
  • = +$5 -$4 (Positive sign denoted inflow and Negative indicates outflow)= +$1 (As this is a positive quantity, this is net inflow or credit)
  1. Net Premium = Sell Call with Strike of $105 & Buy Call with Strike of $115
  • = +$5 -$2= +$3
  1. Net Premium = Sell Call with Strike of $110 & Buy Call with Strike of $115
  • = +$4 -$2= +$2

Practical Example

Let us take an example of Apple Inc. stock and try to build a credit spread strategy and analyze the Profit and LossProfit And LossThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more.

At the end of the trading session on 18th October 2019, the following was Apple’s stock price.

The option chain of Apple for options contracts expiring on 25th October is shown below.

The necessary data is now available for building this strategy.

  • We would deploy a Bullish Credit Spread on Apple Inc. stock just a few minutes before the close of the market on 18th October 2019.The two strikes chosen are $235 and $230. The Puts of each of these strikes have been highlighted. In this case, a $235 strike put will be sold, and the same quantity of $230 will be bought.The prices highlighted on the option chainOption ChainAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions.read more will be used to build the payoff chart of the strategy.

The following result was obtained when the premiums of each of these strikes were fed into the option strategy builder. It can be seen that the strategy has a net credit of $1.12

Source: http://optioncreator.com

The following points are the highlights of the bullish credit spread on Apple Inc. stock.

  • When held till the expiry, the maximum profit is $1.12, which is what is received at the time of deployment of the strategy.When held till the expiry, the maximum loss is $3.88The profit increases linearly as the stock price moves from $230 to $235, which are the two strikes chosen for this strategy.Below $230 & above $235 both the loss and gain are capped to $3.88 & $1.12 respectively.The risk-reward ratioRisk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process.read more is 1.12/3.88 = 0.29

To understand another dimension of this strategy, let us change the strike price of the put bought to $232.50. So, the $235 strike Puts will be sold, and the equal number of $232.50 strike puts that would be now used are:

The following result was obtained when the premiums of each of these strikes were fed into the option strategy builder. It can be seen that the strategy has a net credit of $0.73

It can be observed that:

  • This pair of strikes’ maximum gain and loss are $0.73 and $1.77, respectively.The risk-reward ratio is 0.73/1.77 = 0.41

As the strikes are changed to increase the credit spread, the risk/reward ratio from that strategy will get more skewed towards risk.

Advantages

  • This strategy is naturally hedged and limits the loss to a predetermined quantity, which can be calculated before the strategy is entered. (This phenomenon was observed in the above example of deploying bullish credit spread on Apple Inc. stock. The maximum loss was fixed and pre-calculated)Return on capital blocked as the margin is higher compared to naked option selling (as being spread strategy lesser margin is blocked)Time decay of option acts in favor of this strategy

Disadvantages

  • The maximum profit is limited and obtained right at the time of deployment.The risk/reward ratio is skewed in favor of risk.

Conclusion

This options strategy limits the maximum loss while having the advantage of theta decay, thereby adopting the desirable characteristics of option buying and selling.

This has been a guide to What is Credit Spread options & their Definition. Here we discuss the formula to calculate the credit spread options example, along with types and practical examples. You can learn more about it from the following articles –

  • Calculate Credit SpreadSpread BettingCalculate Option Adjusted SpreadsCall Options vs. Put Options