A credit spread involves selling a high-premium option and buying a low-premium option of the same type (puts or calls) and expiration. The net result is a credit to your account.
Why Trade Credit Spreads for Income? #
- Defined Risk: You know your maximum possible loss the moment you enter the trade.
- High Probability of Profit: You are selling options that you expect to expire worthless, which gives you a statistical edge.
- Income Generation: The goal is to consistently collect premiums as a source of income.
- Flexibility: You can be bullish, bearish, or neutral on a stock and still structure a trade.
The Strategy: Bull Puts & Bear Calls #
Credit spreads come in two main flavors. Your choice depends on your outlook for the stock.
graph TD
subgraph Bullish Outlook
A[Stock Price Expected to Rise or Stay Flat] -->|Choose| B(Bull Put Spread);
B --> C{Sell a Put
e.g., $100 Strike};
C --> D{Buy a Lower Put
e.g., $95 Strike};
D --> E[Collect Net Credit];
end
subgraph Bearish Outlook
F[Stock Price Expected to Fall or Stay Flat] -->|Choose| G(Bear Call Spread);
G --> H{Sell a Call
e.g., $110 Strike};
H --> I{Buy a Higher Call
e.g., $115 Strike};
I --> J[Collect Net Credit];
end
style B fill:#2a9d8f,stroke:#333,stroke-width:2px
style G fill:#e76f51,stroke:#333,stroke-width:2px
1. The Bull Put Spread (A Bullish Strategy) #
Use this when you believe a stock’s price will stay above a certain level. You are selling the right for someone to sell you the stock at a specific price.
- Action:
- Sell a Put Option at a strike price below the current stock price. This is your “short leg.”
- Buy a Put Option at an even lower strike price (same expiration). This is your “long leg,” which defines your risk.
- Example: Stock XYZ is at $105. You are bullish and believe it will stay above $100.
- You sell the $100 strike put for a $2.00 premium.
- You buy the $95 strike put for a $0.50 premium.
- Net Credit: You immediately receive $1.50 per share ($150 for one contract).
- How You Win: The trade is profitable if XYZ closes above $100 at expiration. If it does, both puts expire worthless, and you keep the entire $150 credit. This is your maximum profit.
- How You Lose: If XYZ closes below $100, you start to lose money. Your maximum loss is capped at the $95 strike.
- Maximum Loss: (Difference between strikes - Net Credit) = ($5 - $1.50) = $3.50 per share, or $350.
Profit if stock stays above your short strike. Max profit = credit received. Max loss = width of spread minus credit.
2. The Bear Call Spread (A Bearish Strategy) #
Use this when you believe a stock’s price will stay below a certain level. You are selling the right for someone to buy stock from you at a specific price.
- Action:
- Sell a Call Option at a strike price above the current stock price.
- Buy a Call Option at an even higher strike price (same expiration).
- Example: Stock XYZ is at $105. You are bearish and believe it will stay below $110.
- You sell the $110 strike call for a $2.50 premium.
- You buy the $115 strike call for a $1.00 premium.
- Net Credit: You immediately receive $1.50 per share ($150 for one contract).
- How You Win: The trade is profitable if XYZ closes below $110 at expiration. If it does, both calls expire worthless, and you keep the entire $150 credit. This is your maximum profit.
- How You Lose: If XYZ closes above $110, you start to lose money. Your maximum loss is capped at the $115 strike.
- Maximum Loss: (Difference between strikes - Net Credit) = ($5 - $1.50) = $3.50 per share, or $350.
Profit if stock stays below your short strike. Max profit = credit received. Max loss = width of spread minus credit.
Risk vs. Reward Profile #
| Rewards ✅ | Risks ❌ |
|---|---|
| Limited & Defined Profit: Your max profit is the net credit received. | Limited & Defined Loss: Your max loss is the width of the spread minus the credit. |
| High Probability: You make money if the stock moves in your favor, stays flat, or even moves slightly against you. | Unfavorable Price Movement: A sharp, unexpected move against your position will result in the maximum loss. |
| Time Decay (Theta) is Your Friend: The value of the options you sold decreases every day, which is good for you. | Assignment Risk: Though rare for spreads, the short leg can be assigned early, requiring you to manage the position. |
Best Practices & Money Management #
These guidelines will help you trade credit spreads consistently and manage risk effectively.
- Probability of Profit (POP): When setting up a trade on Schwab’s StreetSmart Edge® or other platforms, look for a high POP. Many traders target spreads with a 70-85% probability of profit. This is often related to the delta of your short strike. A delta of 0.20 implies an ~80% POP.
- Risk/Reward Ratio: Be aware of how much you are risking to make the credit. A common target is to collect a premium that is at least 1/3 of the width of the strikes (e.g., collect $1.00 on a $3-wide spread).
- Days to Expiration (DTE): Spreads with 30-45 DTE are often considered the sweet spot. This provides a good balance of premium and time decay.
- Managing a Losing Trade: If the stock price moves against you, you don’t have to wait to take the max loss. You can “roll” the position out to a later expiration date for an additional credit, or simply close the trade early to cut losses.
Though rare with spreads, the short leg can be assigned early, requiring you to manage the position actively.
Interactive Credit Spread Calculator #
Use the calculator below to analyze a potential credit spread trade.
Credit Spread Calculator
Disclaimer: This content is for educational purposes only and is not financial advice. Options trading involves significant risk and is not suitable for all investors.