Once the trader discovers options understands basic options buying and selling strategies (discussed in Naked call writing and Go long on calls), as well as important pricing dimensions, it’s time to move on to an intermediate level of trading knowledge. This article presents the vertical credit spread, which comes in two forms: the bull set spread and the bear call spread.
The Vertical Credit Spread offers traders an excellent limited risk strategy that can be used with stocks as well as commodity and futures options. These professions, contrary to flow deviationsmainly benefit from decline in the value of time, and they require no movement of the underlying to produce a profit. Let’s start by quickly reviewing what we mean by a credit spread.
Since we are simultaneously buying and selling options with two strikesthere is an outflow of cash when buying one side of the spread and a simultaneous receipt of option premium when selling the other side (i.e. the short side). And these base credit spreads are constructed in equal combinations.
Simultaneously buying and selling options with different strike prices establishes a spread position. And when the option sold is more expensive than the option bought, a net credit results. This is called a vertical credit spread. By “vertical” we simply mean that the position is built using options with the same expiry months. We simply move vertically along the option chain (the strike price chart) to establish the spread in the same exhalation cycle.
Vertical Credit Spread Properties
Vertical credit spreads can be either bearish buying spreads or bullish selling spreads. Although at first it may seem confusing, an examination of each of the “legs”, or each side of the spread, will clarify. Vertical spreads usually have two legs: the long leg and the short leg.
The key to determining if vertical spread is a debit or credit difference is to look at the legs that are sold and bought. As you will see in the examples below, when the leg that is being sold is closer to the money, the vertical spread becomes a credit spread and is generally a net credit representing time value only. A debit spread, on the other hand, always has the short option in the farthest combination of currency, so the debit spread is a net buy strategy.
Table 1 above contains the essential properties of the credit spread strategy. Let’s look at trade setup, strike order, debits/credits and profitable conditions using first an example of a bullish sell spread and then a bearish buy spread. Exhibit 2 contains a profit/loss function for a bullish coffee sell spread.
In Exhibit 2 below we have the July coffee at 58 cents, which is indicated by the black triangle along the horizontal axis. The profit/loss function is the solid blue line on which each kink represents a strike price (we will ignore the dotted functions, which represent profit/loss at different time intervals over the life of the trade). Remember that in a bullish sell spread, just like with a bearish buy spread, we sell the most expensive option (the one closest to the money) and buy the option with a higher strike price. far from the currency (the cheapest). This will create a net credit.
Exhibit 2: Coffee Bull Put Spread
By selling the coffee option with a higher strike price of 55 ($0.029 or $1,087.50) and simultaneously buying the coffee option with a lower strike price of 50 (for $0.012 or $450 ), we generate a net credit of $637.50 with this bullish put. spread. Note that every penny of a coffee futures option is worth $375. As long as at the July expiry coffee is trading at or above the upper strike of 55, we will make that amount as profit (less commissions). Below 55 we start making less profit until we pass the break even (the dotted horizontal line). But the maximum losses are limited here because we have a took a long time option (with a strike price of 50). The profit/loss function therefore becomes flat at this lower strike price (the bend in the lower left corner of Exhibit 2), indicating that losses cannot increase further if coffee were to continue to decline.
With bullish sell spreads and bearish buy spreads (see Figure 3 below), losses are always limited to the size of the spread (the distance between strike prices) minus the net credit original received. In our coffee bullish sell spread, the maximum loss is calculated by taking the value of the spread ($55 – 50 = $0.05 x $375 = $1,875) and subtracting the premium received ($0.029 received for the 55 call minus $0.012 paid for the 50 call, or a net of $0.017 x $375 = $638). This gives us a maximum loss potential of $1,237 ($1,875 – $638 = $1,237).
Take a look at Exhibit 3, which contains a bearish call spread. As shown in Appendix 1 above, the bearish call spreads profits whether the underlying is neutral, bearish or moderately bullish. Just like with the bullish spread put, the bearish call spreads profits even without movement of the underlying, which makes these trades attractive, despite their limited profit profile. Since the net credit generated with a credit spread represents the time value, the spread will reduce to zero at expiration if the underlying has remained stationary or has not exceeded the position’s short strike.
Part 3: Coffee bear call spread
In our coffee bear buy spread (Exhibit 3), we sold the lower 65 call strike and bought the upper 70 call strike for a net credit of ($637.5). Again, each penny is worth $375. The lower strike sold for $937.5 ($0.025 x $375) and the upper strike was bought for $300 ($0.8 x $375). In Figure 3, the profit/loss function looks like a mirror image of the bull put spread. As long as July coffee is trading at or below the 65 strike, maximum profit is achieved with our bearish call spread. If it trades at strike 70 or more, the maximum loss is reached. Maximum profits are limited to the net credit received when establishing the position (less commissions). And the distance between the two strikes minus the bonus received sets the maximum losses. Note that the maximum losses are reached when the underlying increases and not when the underlying decreases. Remember that the bull put spread reaches maximum losses when the underlying falls.
Bullish and bearish credit spreads offer the trader a limited risk strategy with limited profit potential. The main advantage of credit spreads is that in order to earn they do not need a strong directional movement of the underlying. Indeed, trade benefits from the decrease in time value. Vertical credit spreads can therefore benefit if the underlying remains in a Trading range (stationary), freeing the trader from the problems associated with market timing and predicting the direction of the underlying.