When a beginning trader first discovers the world of options he or she usually focuses on debit spreads and never really explores the credit spread avenue. A debit spread is an options spread in which the difference between the long and short options' premiums result in a net debit. On the other hand, a credit spread is where the value of the short position exceeds the value of the long position.

Credit spreads essentially give you the maximum profit upfront, and as a trader you have to hope you will be able to keep all of it or least a significant portion. Credit spreads also come in a variety of combinations, but in this article we will only focus on the basic ones to give you a good feel for these types of positions.

The first credit type of spread is the bull put spread. This position is constructed by purchasing a lower strike put and selling a higher strike put with the same expiration date. The maximum risk is limited to the difference in strike prices times 100, minus the net credit. The maximum profit is the net credit received when the market closes above the short put option with the breakeven point being the higher put strike price, minus the net credit received.

The bull put spread can be used as either an income producing strategy or a wealth building strategy. If the objective is income, then the trader would want to put on the strategy with a 30- to 45-day time frame to expiration. However, the bull put spread can also be done on LEAPS options where you anticipate the underlying to show some appreciation.

The bearish counterpart to the bull put spread is the bear call spread. This strategy is put together by purchasing a higher strike call and selling a lower strike call with the same expiration date. Of course, a trader only wants to put this position on when they anticipate a decrease in the price of the underlying asset below the strike price of the short call option.

Just like the bull put spread, the risk is limited to the difference in strike price times 100, minus the net credit and the maximum profit is achieved when the market closes above the short put option, allowing the trader to keep the net credit received. This particular strategy is typically used as an income strategy with a 30- to 45-day window to expiration.

Bull put spreads and bear call spreads are really the crux of the credit spread strategies. However, there are several other variations that can be employed depending on a particular trader's tolerance for risk. For example, if one wants to bring in a lot of premium but has a lot of risk exposure, he or she can sell straight straddles and strangles without any cap on their risk, which means it requires the trader to take a more active role in the trade management process.

This quite frankly is a very risky way to trade and can quickly ruin an account when adversity strikes. A far better way to go is to straddle or strangle the market by employing the bull put and bear call spread simultaneously and thus capping the risk. In fact, many traders routinely do this each month in liquid markets that they anticipate going sideways to generate income.

There are indeed many variations of credit spreads, each with their own set of margin requirements. The important thing to keep in mind when experimenting with these types of spreads is that if the strategy can be put on as a debit a similar type of strategy can be reversed and put on as a credit. As an options strategist you need to determine if you are comfortable with that particular risk/reward profile.

Happy Trading.


Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff's Forum