option credit spread

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Hals Notebook



An option credit spread is a type of options trading strategy that involves the simultaneous purchase and sale of two options with the same expiration date but different strike prices. This strategy is used to generate income (credit) upfront, and it profits from the time decay of options.


Here's how it works:


Selecting the Options: You choose two options contracts, one to buy and one to sell. These options are typically of the same type (either both calls or both puts) and have the same expiration date.


Choosing Strike Prices: The options you select should have different strike prices. The option you sell (short option) will have a strike price closer to the current market price, while the option you buy (long option) will have a strike price further away.


Credit Received: When you sell the option (short option) with the lower strike price, you receive a credit for it. This credit is essentially the maximum profit potential of the spread.


Limited Risk: The long option with the higher strike price provides protection against potential losses. This means your maximum risk is limited to the difference between the strike prices minus the initial credit received.


Profit and Loss: The goal of an option credit spread is to profit from the passage of time and a decrease in the option's value (time decay). If the options expire worthless, you keep the initial credit as profit. If the market moves against your position, you may incur a loss, but it's limited to the predefined maximum risk.


Example of an Option Credit Spread:


Let's say you're bullish on stock XYZ, which is currently trading at $50 per share, and you expect it to stay above $45. You decide to implement a bullish put credit spread:


Sell to Open (Short Option): You sell one put option with a strike price of $45 for a credit of $2.

Buy to Open (Long Option): You simultaneously buy one put option with a strike price of $40, which costs you $1.

In this example, you've received a $2 credit by selling the $45 put and spent $1 to buy the $40 put. The maximum profit is the credit received ($2), and the maximum loss is the difference in strike prices minus the credit ($5 - $2 = $3).


If at expiration, the stock price is above $45, both options expire worthless, and you keep the $2 credit as profit. If the stock price drops below $45, your maximum loss is limited to $3.


Option credit spreads can be adjusted in terms of strike prices and expiration dates to fit your specific market outlook and risk tolerance. They are popular strategies for generating income while managing risk in options trading.

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