How To Create a credit spread

Credit Spreads allow you as a trader to profit by selling options and letting those options expire worthless.  It also allows you to limit your max risk because you not only sell an option but buy another option.

So let’s look at an example.  We find a stock trading at $74 and we believe that the stock will go up in the short term.  But we may not want to buy the stock or buy an option on the stock because we would only be profitable if the stock does in fact head up higher.

What we can choose to do instead is to sell the $70 put for $2.  This gives us a $2 profit as long as the stock stays above $70.  If it drops below $70 however it can be a major loss because we would have to buy it at $70 and sell it at whatever price it is at. That is a ton of risk.

But lucky we can turn this into a credit spread if we buy the $65 put for say $1.  This means we are only making $1 from the trade instead of $2, but now we are able to limit our max risk to $5 instead of $70, which can be very helpful when looking to limit your loss.

Of course that does not mean that if I took this trade I would be willing to risk the whole $5 just to make $1.  If I was in this trade and it turned against me I would want to cut my losses before it got to my max loss, but if the worst case scenario happened it is good to have a limit on what can happen.

The only downside to this strategy is that you are also limited to how much you can possible make on the upside.  If you sell the $70/$65 credit spread your max gain would be $1, whereas if you bought the stock your max gain is unlimited.  But then again it plays more on probabilities, the spread offers a 20% return in a very short time period, it I unlikely that the stock will make a larger return during the same time period.

For more on credit spreads visit http://www.stocks-simplified.com/credit_spreads.html

For more on other types of option spreads visit http://www.stocks-simplified.com/Option_Spreads.html