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Reducing Risk with Credit Spreads

Reducing Risk with Credit Spreads

Key Points
  • Credit spreads allow options traders to substantially limit risk by forgoing a limited amount of profit potential.

  • With a credit spread, this risk can be quantified—in most cases, you'll know exactly how much money you're risking.

  • Credit spreads are versatile. Most traders are able to find a combination of contracts to take a bullish or bearish position on a stock.

As an options trader, would you like to be able to determine both your profit potential and exactly how much money you're risking? If so, credit spread trading may be for you.

Indeed, spreads can be a useful risk management tool for options traders. When you trade a credit spread, you're swapping a limited amount of profit potential for the opportunity to limit risk. Uncovered options, on the other hand, can have either substantial or unlimited risk, depending on whether you trade uncovered puts or uncovered calls. When you use a credit spread, in most cases, you can calculate the exact amount of risk at the time you enter the position.

Previously, I've discussed the fundamentals of debit spreads and how to use them as an alternative to long options. While debit spreads can limit some of the risk of trading long options, credit spreads can substantially limit the risk of trading uncovered options. Let's find out how.

Strategies to consider

 

Credit spread (vertical spread)

Simultaneous purchase and sale of options in the same class (puts or calls) and same expiration, but with different strike prices.

Credit put spread

Bullish position with more premium on the short put.

Credit call spread

Bearish position with more premium on the short call.

Uncovered (naked) put option

A short put option position in which the writer does not have a corresponding short position in the underlying security.

Uncovered (naked) call option

A short call option position in which the writer does not own the corresponding number of shares in the underlying security.

Source: Schwab Center for Financial Research

Credit put spreads

Let's start by discussing how to use a credit put spread in place of an outright sale of uncovered put options. Although the downside risk of uncovered puts is not quite unlimited, it is substantial, because you could lose money until the stock drops all the way to zero. Credit spreads involve the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying security. In the case of a vertical credit put spread, the expiration month is the same, but the strike price will be different.

The sale of an uncovered put option is a bullish trade that can be used when you expect an underlying security or index to move upward. The goal is usually to bring in money when the uncovered put option is sold, and then to wait until the option expires worthless. When you establish a bullish position using a credit put spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still bring in money when the position is established, but less than you would with an uncovered position. Let's examine this strategy.

Credit put spread example:

Buy 10 XYZ May 65 puts @ .50

Sell 10 XYZ May 70 puts @ 2 for a net credit of 1.50

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes above $68.50 at expiration. You will maximize your profit ($1,500) at $70 or above. You will lose money if the price of XYZ goes below $68.50, and you could lose up to $3,500 if XYZ closes at $65 or below at expiration.

credit put spread

If you had sold the May 70 puts uncovered, you would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced profit potential (in this case $500 of reduced profit potential) is the ability to limit risk significantly. If you simply sold the May 70 puts uncovered, your loss potential essentially would have been $68,000 ($70,000 loss on the stock, less $2,000 premium received on the sale of the puts) if XYZ were to drop all the way to zero. In the case of this credit spread, your maximum loss cannot exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit put spreads work

To better understand the profit and loss characteristics of credit put spreads, let's examine five different price scenarios based on the chart above. We'll assume that once this spread is established, it's held until expiration.

  • Scenario 1: The stock drops significantly and closes at $62 on option expiration. If this happens, you will exercise your 65 puts and sell short 1,000 shares of XYZ stock for $65,000. At the same time, your short 70 puts will be assigned, and you will be required to buy back your short position for $70,000 to close. The difference between your buy and sell price is $5,000. However, because you brought in $1,500 when the spread was established, your net loss is only $3,500. This will be the case at any price below $65. Therefore, this spread is only advantageous over uncovered puts if XYZ drops below $64.50.
  • Scenario 2: The stock drops only slightly and closes at $67 on option expiration. If this happens, you won't exercise your 65 puts, because they're out of the money. However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $67, for $67,000. The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500 at prices from $68.50 down to $65.
  • Scenario 3: The stock closes at exactly $68.50 on option expiration. If this happens, you will not exercise your 65 puts, because they're out of the money. However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $68.50, for $68,500. The difference between your buy and sell price results in a loss of $1,500. However, since you brought in $1,500 when the spread was established, your net loss is actually zero.
  • Scenario 4: The stock rises only slightly and closes at $69 on option expiration. If this happens, you won't exercise your 65 puts, because they're out of the money. However, your short 70 puts will be assigned, and you'll be required to buy 1,000 shares of XYZ at a cost of $70,000. You can then sell your shares at the market price of $69 for $69,000. The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, your net gain is actually $500. This gain will vary from zero to $1,500 at prices from $68.50 up to $70.
  • Scenario 5: The stock rises substantially and closes at $72 on option expiration. If this happens, you won't exercise your 65 puts, because they are out of the money. Your short 70 puts won't be assigned, because they're out of the money as well. In this case, all of the options expire worthless and no stock is bought or sold. However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices above $70.

As you can see from these scenarios, using credit put spreads works to your advantage when you expect the price of XYZ to rise, which will result in a narrowing of the spread price or, ideally, both options expiring worthless.

Credit call spreads

The sale of an uncovered call option is a bearish trade that can be used when you expect an underlying security or index to move downward. The goal is usually to bring in money when the uncovered call option is sold, and then wait until the option expires worthless. When you establish a bearish position using a credit call spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still bring in money when the position is established, but less than you would with an uncovered position.

The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread, except the profit and loss regions are on opposite sides of the break-even point, as shown below. Let's examine this strategy.

Credit call spread example:

Buy 10 XYZ May 80 calls @ .50

Sell 10 XYZ May 75 calls @ 2 for a net credit of 1.50

This spread is executed for a net credit of $1,500 (2 points premium received – .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, you will profit if the market price of XYZ closes below $76.50 at expiration. You will maximize your profit at or below $75. You will lose money if the price of XYZ goes above $76.50, and you could lose up to $3,500 if XYZ closes at $80 or above at expiration.

Credit Call Spread

If you had sold the May 75 calls uncovered, you would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced profit potential (in this case $500 of reduced profit potential) is the ability to limit risk significantly. If you had simply sold the May 75 calls uncovered, your loss potential would have been virtually unlimited if XYZ were to rise substantially. In the case of this credit spread, your maximum loss cannot exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount you were credited when the position was established.

How credit call spreads work

As we did with the credit put spread, let's examine five different price scenarios in light of the chart above to draw a clearer picture of how a credit call spread can work. We'll assume that once this spread is established, it's held until expiration.

  • Scenario 1: The stock rises significantly and closes at $83 on option expiration. If this happens, you will exercise your 80 calls and acquire 1,000 shares of XYZ at a cost of $80,000. At the same time, your short 75 calls will be assigned, and you'll be required to sell 1,000 shares of XYZ for $75,000. The difference between your buy and sell price results in a loss of $5,000. However, you brought in $1,500 when the spread was established, so your net loss is only $3,500. This will be the case at any price above $80. Therefore, this spread is only advantageous over uncovered calls if XYZ rises above $80.50.
  • Scenario 2: The stock rises only slightly and closes at $78 on option expiration. If this happens, you won't exercise your 80 calls, because they're out of the money. However, your short 75 calls will be assigned, and you'll be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at the market price of $78, at a cost of $78,000. The difference between your buy and sell price results in a loss of $3,000. However, because you brought in $1,500 when the spread was established, your net loss is only $1,500. Your loss will vary from zero to $3,500 at prices from $76.50 up to $80.
  • Scenario 3: The stock closes at exactly $76.50 on option expiration. If this happens, you won't exercise your 80 calls, because they're out of the money. However, your short 75 calls will be assigned, and you will be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,500. The difference between your buy and sell price results in a loss of $1,500. However, because you brought in $1,500 initially when the spread was established, your net loss is actually zero.
  • Scenario 4: The stock drops only slightly and closes at $76 on option expiration. If this happens, you won't exercise your 80 calls, because they're out of the money. However, your short 75 calls will be assigned, and you'll be required to sell short 1,000 shares of XYZ for $75,000. You can then close out your short position by purchasing 1,000 shares of XYZ at a cost of $76,000. The difference between your buy and sell price results in a loss of $1,000. However, because you brought in $1,500 when the spread was established, you actually have a net gain of $500. This gain will vary from zero to $1,500 at prices from $76.50 down to $75.
  • Scenario 5: The stock drops substantially and closes at $73 on option expiration. If this happens, you won't exercise your 80 calls, because they are out of the money. Your short 75 calls won't be assigned, because they are out of the money as well. In this case, all of the options expire worthless and no stock is bought or sold. However, because you brought in $1,500 when the spread was established, your net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices below $75.

As you can see from these scenarios, using credit call spreads works to your advantage when you expect the price of XYZ to fall, which would result in a narrowing of the spread price or, ideally, both options expiring worthless.

Before you consider the sale of uncovered calls or puts, consider the amount of risk you may be taking and how that risk could be significantly reduced through the use of credit spreads.

Advantages and disadvantages of spreads

To summarize, credit put and call spreads have both advantages and disadvantages compared to selling uncovered options.

Advantages include:

  • Spreads can lower your risk substantially if the stock moves dramatically against you.
  • The margin requirement for credit spreads is substantially lower than for uncovered options.
  • It is not possible to lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.
  • Debit and credit spreads may require less monitoring than some other types of strategies because once established, they're usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warranted—for example, if the underlying instrument moves enough, you may be able to close out the spread position at a net profit prior to expiration.
  • Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders are able to find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.

Disadvantages include:

  • Your profit potential will be reduced by the amount spent on the long option leg of the spread.
  • Because a spread requires two options, the commission costs to establish and/or close out a credit spread will be higher than the commissions for a single uncovered position.

Next Steps

  • Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
  • Not yet a client? Learn more about Schwab Trading Services.
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