Options are a derivate instrument, and their value is dependent on the underlying assets. It’s used to realize speculation on the movement of an underlying asset. If the price of the underlying asset moves in expectation of the buyer of the options, it generates a financial return for them. The other side movement can lead to massive losses.
So, certain trading techniques have been introduced to control an element of the risk on the speculation. These techniques on a broader spectrum include credit spread options and debit spread options. In this article, we shall discuss different characteristics of credit spread.
Credit spread
Credit spread refers to a strategy for dealing with the options. It’s about selling an option and buying another option with the same maturity date. However, the strike price for the options should be different. The science behind the idea is that premiums paid and received are different due to differences in the strike price, although the underlying asset is the same. Hence, the net premium is realized when entering the options.
It’s further important to note that trader writes/issues high premium options and receive low premium options. The net difference between payment and receipt is a net credit; that’s why it’s called credit spread.
Suppose the current price of an underlying asset is $70. The trader implements a credit spread strategy, writes/issues call options at a strike price of $60, and premium to be received $6 at certain maturity. At the same time, the trader buys a call option at a strike price of $80 and pays a premium of $2. That’s the credit spread. It means the trader receives more premium by $4 ($6-$2).
Further, it’s important to note that traders profit when the spread of options narrows. The reason can be understood with the help of the following discussions.
So, if the price goes down, it’s a wise choice not to exercise call options (purchased) and forego the premium of $2.
Similarly, the buyer of the option is not expected to exercise his right to purchase security from the trader. Hence, a trader has earned $6. So, the net earnings of the trader are $4($6-$2)
If the price goes up, it’s against an expectation of the trader as there was an expectation of making a profit by a decline in the value. However, the price has gone up, which create a loss for the trader as speculation has gone wrong, and buyer is highly likely to exercise their right of purchase at a lower strike price.
Further, the maximum return of the trader is the net of the premium received and realized when the spread goes down. The return can be generated on credit spread through different ways and a different set of purchases and sales. Generally, the trader is either bearish or bullish. Further, there can be different credit spread options strategies that include short butterfly and condor strategies. Let’s discuss the details of these strategies.
1. Butterfly strategy
This credit spread strategy involves both bullish and bearish sentiments of the investors. This strategy enables an investor to presume fixed risk on the investment strategy. However, it caps the investor’s profitability or returns generating ability. So, it’s a neutral investment strategy adopted by traders.
This strategy involves setting four put and four call options, or it can be a combination of the call and put option with three different strike prices and the same expiry. The maximum return is generated from such a strategy when the underlying asset’s price does not move either in an upward/downward direction before expiry. Further, three strike prices need to be in the following format.
Higher strike price – Higher of all three strike prices in the strategy.
Lower strike price – Lower of all three strike prices in the strategy.
At the money strike price, the amount to reach the upper/lower limit should be the same by addition and subtraction.
For instance, if the lower strike price amounts to $50, the higher strike price amounts to $60. The money strike price should be $55 as we can add $5 and reach $60. Similarly, $5 can be deducted to reach $50.
Further, there can be different types of butterfly spreads that include long call butterfly spread, short call butterfly spread, long put butterfly spread, short put butterfly, iron butterfly spread, and reverse iron butterfly spread.
Long call butterfly spread
This type of strategy is when a trader buys an in the money call option at a lower strike price. And issues/write two at the money call options with a higher strike option. In addition to these, buying out of the money call option at the higher strike price.
In the money call option is when the market value of the underlying asset is higher than the strike price. On the other hand, the money call option is when the market value of the underlying security is very near to the strike price.
The strategy generates maximum return when there is no change in the valuation of the underlying asset. It means the underlying asset remains the same in the value at the time of expiry as at the time of write-off. Further, the loss is capped on the initial cost of premium and commission.
Short call butterfly spread
This type of strategy is when the trader sells and buys two at the money call option, one in the money call option at a lower strike price, and sales one out of the money option at a higher strike price. This results in net credit receipt via premium against the presumption of the risk.
Further, the maximum profit on this strategy is limited to the initial premium received net of commission. Similarly, the maximum loss is limited to the purchased options’ strike price less strike price on a lower strike.
Other butterfly strategies include long put butterfly, short put butterfly, Iron butterfly, reverse iron butterfly, etc. These strategies neutralize the risk and cap profit and loss for the investors.
2. Condor strategy of options
Condor strategy of options is designed to limit both return and losses in both directions of the high and low volatility. Further, there are two types of condor strategies: short condors and long condors.
The longer condors comprise four options at different strike prices in a row. The chances of making a profit on such options are higher when options are trading in a narrow range. However, there is a limitation on the potential of the business to generate profit.
Conclusion
Options are the derivate instruments that drive value from the underlying assets. The options do not have an innate value instead depend on other underlying assets. If the value of the underlying asset increases, the value of options increases and vice versa.
Investors implement different strategies to invest in the options. Credit spread is one of the strategies to invest in options and neutralize their portfolio, limiting risk and loss. Although, the strategy can restrict investment potential to generate the return.
The risk is managed by setting different selling and buying options to call/put. Generally, credit spread contains selling and buying options at the same level of maturity at different strike prices. Such a strategy caps the profits and limits the losses as an option is purchased and sold for the same underlying asset.
Further, the credit spread can be divided into two types: butterfly and condor strategy. These strategies are a little complex to implement. However, these are effective strategies in neutralizing the risk.
Frequently asked questions
What are the advantages of dealing in options for the trader?
The advantages of the options include but are not limited to cost efficiency of entering in the options, les risk contained in the instruments than equity and other financial instruments, higher potential of return on the options or greater potential for the profit, and multiple strategies to manage the risk and return.
So, the characteristics of the options make it a good choice for the traders and hedgers. However, the trader is expected to have a clear understanding of trading to implement the strategy.
What is meant by credit spread?
There are two meanings of credit spread. One is related to the bonds, and the other is related to the options strategy.
The credit spread on the bond is the difference between the corporate bond yield and the yield on the Treasury bond backed by the Government. On the other hand, credit spread on options is a strategy that buys and sells options to manage the risk and earn profit. So, the term needs to be interpreted contextually.
What’s the benefit of dealing in credit spread options?
The greatest benefit of the credit spread option is to limit the risk of loss. Although, it comes at the loss of restriction for the investment’s potential of return generating ability. It’s achieved by purchasing and writing a different call and put options. The implementation of strategies makes it attractive trading options.
What are the disadvantages of dealing with options?
The disadvantages of dealing in options include taxes on the capital gains, commission expenses on the buying and selling of the options, uncertainty of dealings return, and other procedural formalities to deal in the options.
