Credit Spreads Using Put Options

January 6, 2010

Credit spreads can be an effective way of trading market direction. Important decisions that must be considered when using a credit spread include selecting the timeframe for the options as well as the difference in the strike prices. Factors that influence these decisions are associated with the degree to which the trader is bullish or bearish.

The first type of credit spread discussed in this aricle is called a Bull Put Spread. Naturally, puts decrease in value as the underlying market trades higher. When we use a Bull Put Spread, we want to see the market rally.

In order to establish a Bull Put Spread, a Put option is sold, while another put option with a lower strike price is bought. Typically, you use the same expiration months for each option.

The put option with the higher strike price has more value than the put option with the lower strike price. Therefore, the net cost of the transaction would be a credit – thus the term Credit Spread is applicable for this type of strategy.

The best case scenario would be for the market to rally higher than the higher put strike price, at expiration. If this happens, then the maximum profit is earned, as both options are completely worthless and the entire credit is earned.

One does not need to hold this type of option spreaad trade until expiration in order to earn profit (nor is it necessarily recommended to hold the position until expiration). The most import consideration is market direction – if the market rallies, a Bull Put Spread should increase in value.

Example (note that these prices are for illustration only):

Consider a May 430 Corn Put option priced at: 30 cents. The dollar value of this would is $1500.
Consider a May 390 Corn Put option priced at: 12 cents. The dollar value of this would is $600.

If one were to sell the May 430 Corn Put and simultaneously purchase the May 390 Corn Put, we would earn or generate a credit of $900. This also happens to be the maximum amount that can be made on this spread (less fees and commission).

The maximum loss on this spread would be if the market sold off and was below the lower strike price at expiration. If this happened, we would be “theoretically” long Corn Futures at the higher strike of 430’0 and short Corn Futures at the lower strike of 390’0. This represents a 40 cent loss. The maximum loss is computed as follows: the difference in srike prices is 40 cents, which = $2,000. However, recall that we earned a $900 credit when the spread was established. The maximum loss would be $2,000 – $900 = $1100 (plus fees and commission).

NOTE: A wise trader would not let this position deteriorate into a worst-case scenario and would never risk $1100 in order to make $900. Normally, we use software to graph out what are spread position would be worth at different points in time and at different price levels of the underlying futures market. This allows us to determine at what level the underlying market would be at if we were to build money management into our trade. For example, if we are willing to risk $300 to make $900, then we would use software to analysis where the underlying market would need to trade (theoretically) in order for our spread to be purchased for $1200, which would represent our loss.

Leave a Comment

Next post: