Equodity

A credit spread is very similar to a debit spread. You are using two options to create a max profit and a max loss. The difference is you are taking in money on this trade and not paying for the trade. So your risk is the opposite of the same side debit spread.A debit call spread is bullish where a credit call spread is bearish. In this type of spread you will sell the lower call strike price and buy the higher call strike price for the same month. Keeping the spreads vertical for debit and credit spreads to begin with keeps the math simple and the strategy easy to understand. If you try to combine this with a horizontal spread you will change your risk graph and possible expose yourself to a naked position.

Also I would not recommend horizontal credit spreads for European style options because if you get executed on your front month (because you forgot to sell or you thought the 5 cents below the strike would expire) you wont be able to cover your obligation with your other position.

I have found that this strategy really isn’t very effective for trading accounts with less the twenty thousand dollars in it. Here is why: If you display adequate options strategy knowledge to your broker they will allow you to trade spreads so long as the end results doesn’t leave you naked or with a possible loss greater then your account value.

They know that you cant loose more then the spread value and they wont allow you to trade a position that will put you into a loss more then your account can handle. They do this by holding your credit and then holding the difference between your max loss and your credit.

So while they will pay you interest on this amount being held, they will not allow you to trade the amount you just took in on this “credit”. Conversely if you would have traded for the same direction in a debit spread, the max you can loose is your initial debit, so you don’t have to worry about the rest of the spread and they don’t hold any more.

Here are some examples.

March ‘08

Credit spread (Bearish Position)

Calls

Ticker	Bid	Ask	Open	Strike	Buy / Sell
APVCE	4.45	4.50	23093	125	Buy
PYPCL	7.15	7.25	11349	120	Sell

Sell the 120’s at 7.15 and buy the 125’s for 4.50 giving you a credit of 2.65 giving us a max loss of 5 net of the credit of course. Your max profit is only 2.65, what you sold the position for, so now you sit and wait, if you are right and the stock drops you keep your 2.65. Again though, the brokerage will hold all 5 in the event that you are wrong and need to pay it out. If you would have bought the bearish debit spread you could have bought double the position and been reward doubly if you were right. If you are wrong you are in a similar position as the bearish credit spread.

Credit Spread (Bullish Position)

Puts

Ticker	Bid	Ask	Open	Strike	Buy / Sell
QAAOD	3.40	3.50	21870	120	Buy
APVOE	5.70	5.75	11349	125	Sell

In this instance we want AAPL to appreciate in value by the end of the month. So we would sell the 125’s for 5.70 and buy the 120’s for 3.50 for a net credit of 2.20. The max loss again is 5, so if the stock in deed drops we are covered beyond the 120 mark, but we have to give back our 2.20 credit plus 2.70 more as that was our risk for this position.

(APVCE: 0.00 N/A, vol: 0, avg vol: 0)
(PYPCL: 0.00 N/A, vol: 0, avg vol: 0)
(QAAOD: 0.00 N/A, vol: 0, avg vol: 0)
(APVOE: 0.00 N/A, vol: 0, avg vol: 0)