Lesson 14: What are credit spreads?

The credit spread is an options strategy where you buy and sell options of the same class — that is, the same underlying asset, expiration date and option type — with different strike prices. This trade initially produces a net credit to your trading account.

A debit spread is similar in some ways, but that trade initially results in a net debit to your trading account.

Remember, the terms credit or debit don’t refer to the trade’s result. You can end up with a profit or loss with either trade, depending on the success of your strategy. And either strategy can be used to express a bullish or a bearish opinion on a stock or ETF.

Let’s dive into credit spreads.

A call credit spread involves selling one call option and buying another with a higher strike price. Both options have the same expiration date and underlying stock or ETF. This strategy is also known as a bear call spread.

Typically, the amount you receive when you sell the lower strike call is greater than the amount you pay to buy the higher strike call, which results in a net credit to open the position. The name spread comes from the fact that the value of the position is based on the difference or spread between the two strike prices.

A call credit spread is a bearish strategy because, ideally, you expect the price of the stock to move or remain below the lower strike price, the strike price of the call you’ve shorted. You might use this strategy when you believe the stock will move moderately lower. Because the position also benefits from time decay and declining implied volatility in the shorted call, the strategy also benefits to some extent if the stock moves very little, although the long call would be negatively impacted in that scenario.

The maximum profit possible on this position is the proceeds of the short sale less what was spent to buy the long call. As a result, the strategy can’t fully benefit from a large decline in the stock. If you anticipate a large decline, the purchase of a put may be a better way to capitalize on that potential move.

Contrast the call credit spread with simply shorting a call option without holding the underlying stock — also known as an uncovered or naked short call. The uncovered call has unlimited risk, limited profit potential and a high margin requirement. With the call credit spread, the risk is reduced by the presence of the long higher strike call, which caps the potential loss on the spread at the difference between the two strikes less the net credit received when the trade was initiated. The long call also reduces the margin requirement for the position. The trade-off is that potential profit is also reduced by the amount spent for the long call.

A put credit spread involves selling one put option and buying another with a lower strike price. Both options have the same expiration date and underlying stock or ETF. This strategy is also known as a bull put spread.

Typically, the amount you receive when you sell the higher strike put is greater than the amount you pay to buy the lower strike put and you’ll receive a net credit to open the position. As mentioned, it’s called a spread because the value of the position is based on the difference or spread between the two strike prices.

A put credit spread is a bullish strategy because, ideally, you expect the price of the stock to move or remain above the higher strike price. You might use this strategy when you believe the stock may make a modest move to the upside, but you think that move will likely be limited.

Because the position also benefits from time decay and declining implied volatility in the shorted put, the strategy also benefits to some extent if the stock moves very little, although the long put would be negatively impacted in that scenario.

The maximum profit possible on this position is the proceeds of the short sale less what was spent to buy the long put. As a result, the strategy can’t fully benefit from a large rise in the stock. If you anticipate a large rise, the purchase of a call may be the best way to capitalize on that potential move.

Contrast the put credit spread with simply shorting a put option without holding a short position in the underlying stock — also known as an uncovered or naked short put. The uncovered put has identifiable but potentially substantial risk, limited profit potential and a high margin requirement. With the put credit spread, the risk is reduced by the presence of the long lower strike put, which caps the potential loss on the spread at the difference between the two strikes less the net credit received when the trade was initiated. The long put also reduces the margin requirement for the position. The trade-off is that potential profit is also reduced by the amount spent for the long put.

To build a credit spread, select an underlying stock or ETF, choose an expiration date and two strike prices. Typically, both strike prices are out-of-the-money. As already discussed, in a call credit spread, sell a call with a lower strike and buy a call with a higher strike. In a put credit spread, sell a put with a higher strike and buy a put with a lower strike. You’ll receive a net credit to open the position.

• You can execute a credit spread as a multi-leg trading strategy by specifying the net price you want to pay. The net price will equal the proceeds of the higher value, short side of the trade less the amount paid for the less expensive, long side. Both parts of the trade have to be filled at the same time, at the total price you specify or better. If those conditions aren’t met, the trade won’t execute. In essence, it’s a form of contingent order — both parts get filled or neither do.
• You may receive a partial fill on a credit spread, but only in the ratio that you’ve specified. For example, if you’re buying 10 calls and selling 10 calls, you may be partially filled on 1 long call and 1 short call. Your fill will always reflect the specified ratio — in this example, 1 short call for every 1 long call.

• With this trade style, you place your order for the long calls or puts and the short calls or puts as separate orders. This can be done consecutively, if you’re looking for an opportunity to secure a more advantageous price on one or the other side of the trade, or simultaneously.
• Executing the trade this way will require much higher available margin in your account and a higher level of option trading approval. Note that the risk for the short side of the trade will be substantial for a short put or unlimited for a short call until the long side of the trade is executed. The risk is reduced if the long side of the trade is executed first.
• This is also known as “legging in” to a strategy.

If your credit spread is profitable before expiry, meaning that you could close both legs of the position and still keep a substantial portion of your original credit, you may want to close it before expiration. This allows you to control the outcome of the trade, although you may not realize the maximum profit the trade could achieve.

There are a number of scenarios that may require you to take action as the position nears or reaches expiry. Carefully review the "What happens at expiration" section of this article for details.

As mentioned, you might consider closing your position before expiry to free up capital and avoid the risk and cost of going through exercise and assignment.

You have the choice to sell to close the spread as a multi-leg strategy, close each leg separately or hold the position through expiration.

• If the stock’s price is above the short strike price for a put, or below the short strike price for a call. Both options should expire worthless. You’ll keep the proceeds of the shorted option less the amount spent to purchase the long option.
• If the stock’s price is below the long strike price for a put, or above the long strike price for a call, both options will expire in-the-money. You’ll likely be assigned on your short put or call and your long put or call may be automatically exercised, but this is not guaranteed. You'll need to make sure you have sufficient available margin to cover the exercise and you should contact us to make sure the exercise takes place, if that is part of your strategy. Since the exercise of the long option limits your liability on the short option, it’s important that you take steps to ensure this will happen in this scenario.
• If the stock closes between the short strike and long strike prices, your short position may be automatically assigned, and your long position will expire worthless. This will likely result in your account receiving a short stock position, in the case of a call credit spread, or a long stock position, in the case of a put credit spread. You’ll need to make sure you have sufficient available margin to cover the assignment.

• You’ve sold 10 XYZ put options with a strike price of $100 and bought 10 XYZ put options with a strike price of $95 and the same expiration date. You’ll receive a credit when you initiate this position.
• At expiry, if XYZ trades above $100 per share: both options expire worthless. You’ll keep the proceeds of the shorted option less the amount spent to purchase the long option.
• At expiry, if XYZ trades under $95 per share: both options expire in-the-money. You’ll be assigned on your short put and your long put may be automatically exercised. However, you’ll need to make sure you have sufficient available margin to cover the exercise and you should contact us to make sure the exercise takes place, if that is part of your strategy. By collapsing both the long and short sides, you’ll recognize a loss of $5,000 (10 x 100 x $5), which will be partially offset by the upfront net premium, and you’ll have no remaining open positions.
• At expiry, if XYZ trades between $95 and $100: only the short put expires in-the-money and you will be assigned a long XYZ stock position. You’ll be debited $100,000 (10 x 100 x $100) to fund the purchase of the stock. Your margin requirement may range from 30% to 100% of the stock value, meaning a margin requirement of $30,000 to $100,000. This is significantly higher than the original margin requirement of the credit put spread.
• The assignment of a short option can trigger a margin call or liquidation if there isn’t sufficient cash or account equity to support the margin requirement.

In a call credit spread at expiration, the breakeven is equal to the lower strike price plus the net premium you received when you opened the position. Your losses are capped once the stock price moves above the higher strike price.

In a put credit spread at expiration, the breakeven is equal to the higher strike price minus the net premium you received when you opened the position. Your losses are capped once the stock price moves below the lower strike price.

Any time you have a short option in your position, there’s the possibility of early assignment. This exposes you to certain risks, such as being unexpectedly long or short the underlying stock.

An early assignment occurs when an option that was sold is exercised by the long option holder before its expiration date.

If you’re assigned on the short put option of your put credit spread, you can take one of the following actions by the end of the following trading day:

• Sell the shares at the current market price.
• Exercise your long put option, meaning that you’ll sell the shares at the long strike price.

If you’re assigned on the short call option of your call credit spread, you can take one of the following actions by the end of the following trading day:

• Buy the shares at the current market price.
• Exercise your long call option, meaning that you’ll buy the shares at the long strike price.

In addition to possible early assignment, corporate actions, such as stock splits, reverse stock splits, mergers or acquisitions, can impact the underlying stock and subsequently affect the options held. These actions may cause changes to the option's structure, price or deliverable. Stay informed about any corporate actions that may impact your positions. You can do this by regularly checking both your account holdings and any news on the stock.

It’s your responsibility to verify that your holdings continue to reflect the objectives of your chosen trading strategies.

Next up is Lesson 15: Options approval and placing a trade.