Credit Spread Trading Strategy (Profit, Risk, Backtest)

What Is a Credit Spread in Options Trading?

A credit spread is a widely used option trading strategy that involves simultaneously buying and selling options on the same underlying asset.

This is how it works:

The trader sells a higher-premium option while purchasing a lower-premium option, resulting in a net credit to their account.

Credit spreads are typically used by traders who expect the underlying asset to remain relatively flat or move in a certain direction, but not too far. We’ll explain the risks later in the article. 

Two types of credit spreads

There are two main types of credit spreads:

Vertical credit spreads and diagonal credit spreads.

Vertical credit spreads involve selling a higher-strike option and buying a lower-strike option.

Diagonal credit spreads involve selling a higher-strike option with an earlier expiration date (and therefore a higher premium) and buying a lower-strike option with a later expiration date (and therefore a lower premium).

Credit spreads – profits and losses

The maximum profit that a trader can make from a credit spread is the net credit received when the position is opened. The maximum loss is limited to the difference between the strike prices of the sold and bought options, multiplied by the price of the underlying asset.

Credit spreads are a relatively low-risk option trading strategy, as traders do not need to deposit any margin to open a position.

However, traders should be aware that credit spreads can still lose money if the underlying asset moves significantly against them. But the max potential loss is given, and you can’t lose more than a certain amount. You don’t risk devastating losses. 

An example of the profits and risk you can make is illustrated here:

At the time of writing we can do the following vertical credit spread in Apple:

• Buy a AAPL calls, strike 100, expiry 17th of May, for 8570 for 100 contracts;
• Sell/write AAPL calls, strike 110, expiry 17th of May, for 7495 for 100 contracts. 

Your max loss is thus 1075 USD (8570 – 7495).  

Credit spreads – key terms

Options trading might be like Greek to many. If so, we recommend reading the basics of options terminology.

Here are some key terms to know about credit spreads:

• Strike price: The price at which the option can be exercised. 
• Premium: The price paid for an option.
• Net credit: The difference between the premium received from the sold option and the premium paid for the bought option.
• Buy to close: An order to close out a long option position by buying the same option at the current market price.
• Sell to close: An order to close out a short option position by selling the same option at the current market price.
• Expiry: the date when the options expire (options have a finite life)

How Do Credit Spreads Work?

Credit spreads are a type of options trading strategy involving the simultaneous purchase and sale of two options on the same underlying asset with different strike prices and expiration dates.

The goal is to generate a net credit, or premium, at the time the spread is opened.

Let’s provide you with an example of a credit spread:

To construct a credit spread, an investor will typically sell a higher-strike call option and buy a lower-strike call option (bullish credit spread) or sell a lower-strike put option and buy a higher-strike put option (bearish credit spread).

The profit or loss of a credit spread depends on the price movement of the underlying asset relative to the strike prices of the options.

If the price of the underlying asset moves in the expected direction, the investor will make a profit. However, if the price of the underlying asset moves against the expected direction, the investor will lose money.

Credit spreads are typically used to reduce risk and generate income. They are a relatively conservative trading strategy, but they can still be profitable if they are properly constructed and managed.

Credit Spread Trading Strategy – backtest and trading rules

It’s hard to backtest a basket of many credit spreads, while it’s easy to backtest one credit spread. 

However, the webpage OptionAlpha has done all the work for us. In an article called 5-Year SPY Put Credit Spread Backtest they explored the historical performance of SPY put credit spreads. By the way, we recommend that website if you are into options trading. 

They backtested a put credit spread for a period of 5 years with rolling expiries. A put credit spread buys a put with a lower strike price than the one you sell/write. As a result you receive a net credit. 

How has such a systematic strategy performed on SPY, the ETF that tracks S&P 500?

OptionAlpha calculated an unlevered CAGR of 3.1%. It comes with a max drawdown of 12.2% and a Sharpe Ratio of 0.56, Sortino Ratio of 0.18, and profit factor ratio of 1.5.  

However, the best way to understand these options trading strategies, is to play around with an option calculator. And when you believe you understand the strategy, then trade the lowest possible size you can. 

Types of Credit Spreads: Bull Put vs. Bear Call

Credit spreads, also known as net credit spreads, are a type of options strategy that involves the simultaneous purchase and sale of options contracts with the same underlying asset, expiration date, but different strike prices.

The strategy aims to profit from a narrowing of the spread between the two options’ premiums.

Bull Put Spreads

A bull put spread is a bullish strategy that is used when an investor expects the underlying asset to remain relatively stable or increase in price.

The strategy involves selling a put option with a lower strike price and buying a put option with a higher strike price. The premium received from selling the lower-strike put option is greater than the premium paid for the higher-strike put option, resulting in a net credit to the trader’s or investor’s account.

The maximum profit for a bull put spread is limited to the net credit received, and losses are limited to the width of the spread between the two strike prices.

Bear Call Spreads

A bear call spread is a bearish strategy that is used when an investor expects the underlying asset to move downward in price.

The strategy involves selling a call option with a higher strike price and buying a call option with a lower strike price. The premium received from selling the higher-strike call option is greater than the premium paid for the lower-strike call option, resulting in a net credit to the trader’s or investor’s account.

The maximum profit for a bear call spread is limited to the net credit received, and losses are limited to the width of the spread between the two strike prices.

Selecting the Right Underlying Asset for Credit Spreads

When choosing an underlying asset for a credit spread, it’s crucial to consider factors like liquidity, volatility, and personal trading goals. What are you trying to achieve? Why would trade credit spreads?

Liquidity refers to the ease with which an asset can be bought or sold without significantly impacting its price. Options on liquid assets are easier to trade and more likely to generate consistent returns.

Volatility measures the degree to which an asset’s price fluctuates. For credit spreads, moderate volatility is ideal. Too low volatility may limit the potential profit, while excessive volatility increases the risk of losing money. Please keep in mind that future and historical volatility is one of the main factors influencing the price of an option. 

Personal trading goals also influence the asset selection. If aiming for a quick profit, a highly volatile asset might be suitable. Conversely, if seeking a more conservative approach, a stable asset with smaller price swings might be preferred.

Risk and Reward in Credit Spread Trading

The defining feature of credit spreads is the receipt of a net credit, essentially a premium, upon establishing the position.

This premium represents the maximum profit potential, which is capped and predetermined. The downside risk, however, is significantly lower than alternative options strategies, such as naked calls or puts.

The key to managing risk in credit spreads lies in selecting the appropriate strike prices. By carefully considering the underlying asset’s price movement expectations, traders can tailor their spreads to achieve their desired risk-reward profile. A credit spread strategy typically profits when the underlying asset’s price moves within a predefined range, known as the spread.

To further mitigate risk, traders can employ strategies like rolling, which involves adjusting the strike prices and expiration dates to extend the position’s life and potentially salvage any remaining value.

Additionally, using stop-loss orders can help limit potential losses if the underlying asset moves against the trader’s expectations, but this is not something we recommend. That involves a lot of slippage, and moreover stop loss orders are not very helpful.

Credit spreads offer a viable options trading approach for those seeking moderate profits with relatively controlled risk. It’s not for those looking for a home run!

Credit Spread Trading Strategies: Entry and Exit Points

The goal is to generate a profit from the premium collected when selling the option, which is typically greater than the cost of buying the other option.

Entry Points

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  Select an underlying asset with strong price movement potential. Credit spreads are most effective when the underlying asset is volatile, as this increases the likelihood that one of the options will expire worthlessly, generating a profit for the trader. However, markets are efficient, meaning that this might already be priced in the premium.

  
  
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  Choose strike prices that are aligned with your directional bias. For a bullish credit spread, sell a put option with a lower strike price and buy a put option with a higher strike price. For a bearish credit spread, sell a call option with a higher strike price and buy a call option with a lower strike price.

  
  
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  Consider the time decay of options. Credit spreads tend to be profitable when the time to expiration is longer, as there is more time for the options to expire worthless.

  
  

Exit Points

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  Close the position for a profit if the underlying asset price moves in your favor and one of the options is deep in the money. This is the ideal outcome for a credit spread.

  
  
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  Close the position for a loss if the underlying asset price moves against you and one of the options is deep out of the money. The maximum loss for a credit spread is the net premium received when entering the trade.

  
  
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  Adjust the position if the underlying asset price moves closer to the strike price of the options. This could involve buying back one of the options to reduce risk or selling the other option to increase potential profit.

  
  

Advanced Credit Spread Techniques

Unlike buying options outright, which exposes traders to unlimited losses, credit spreads cap potential losses and offer defined profit potential.

Ratio Spreads

Ratio spreads involve selling a greater number of options than are purchased. This increases the potential profit but also increases the risk of assignment, making it a more aggressive strategy.

Iron Condors

Iron condors are a complex strategy that combines both put and call credit spreads, creating a symmetrical profit zone. They are suitable for traders who expect the underlying asset to remain relatively stable within a specified range.

Adjustments

Common adjustments include rolling out or in the expiration date, adjusting the strike prices, or closing the position altogether.

Key Terms in Credit Spreads

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  Net Credit: The initial premium received by the trader when establishing the spread.

  
  
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  Strike Price: The price at which an option contract can be exercised.

  
  
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  In-the-Money (ITM): An option that has a strike price below the current underlying asset price for calls or above the current underlying asset price for puts.

  
  
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  Out-of-the-Money (OTM): An option that has a strike price above the current underlying asset price for calls or below the current underlying asset price for puts.

  
  
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  At-the-Money (ATM): An option that has a strike price equal to the current underlying asset price.

  
  

Conclusion

In conclusion, the credit spread trading strategy is a tool for investors seeking to capitalize on market volatility while managing risk.

By simultaneously buying and selling options contracts with different strike prices, traders can generate consistent income and limit potential losses. However, you won’t strike any home runs with this strategy.