There are two simple ways to define Credit Spreads. These are as follows :
- The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
- An options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.
For instance, the difference between yields on treasuries and those on single A-rated industrial bonds. A company must offer a higher return on their bonds because their credit is worse than the government’s. Credit spreads can also be called “credit spread option” or “credit risk option”.
In finance, a credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit. In contrast, an investor would have to pay to enter a debit spread.
One uses a credit spread as a conservative strategy designed to earn modest income for the trader while also having losses strictly limited. It involves simultaneously buying and selling (writing) options on the same security/index in the same month, but at different strike prices. (This is also a vertical spread)
If the trader is BEARISH (expects prices to fall), you use a bearish call spread. It’s named this way because you’re buying and selling a call and taking a bearish position.
Breakeven
To find the credit spread breakeven points for call spreads, the net premium is added to the lower strike price. For put spreads, the net premium is subtracted from the higher strike price to breakeven.
Most brokers will let you engage in these limited risk / limited reward trades.
Maximum potential
The maximum gain and loss potential are the same for call and put spreads. Note that net credit = difference in premiums.
Maximum gain
Maximum gain = net credit, realized when both options expire.
Maximum loss
Maximum loss = difference in strike prices – net credit.