Trading Credit Spreads Explained

Credit spread is the difference in the premiums of two options — one that you plan on selling, and another one that you plan to buy. The strategy for trading credit spreads is simple in principle — let’s explore!

Here’s the deal: a trader buys an option in lieu of another option of the same category that they plan on selling. Traders often buy options for lower premiums (in the same category) as compared to the ones they’re about to sell.

When they sell the higher premium option, they can keep the difference in premiums as profit — simple, right?

However, the trader must first identify the best stocks for credit spreads.

Let’s dive in and explore how selling credit spreads for income works!

How to Trade Credit Spreads Effectively

Traders buy an option for a lower premium than the one they’re about to sell. Both of the options should be in the same category but with different premiums.

The difference in the premiums is the net gain of the trade.

This is what the trader makes when they sell the higher premium option.

So, are credit spreads profitable?

Well, yes, that’s the whole point!

Beyond profitability, using credit spreads is mostly a safety measure. It becomes necessary when the issuer of a security or option is likely to default.

Let’s move on to see how credit spreads vs debit spreads compare.

Debit Spreads vs Credit Spreads: Which is Better?

Compared to credit spreads, debit spreads are the exact opposite. In this case, a trader buys another option for a higher premium than the one they’re about to sell. Traders do so when they want to minimize the potential loss of holding an option.

By selling an option of the same category (but with a lower premium) earlier on, they can cut down any potential losses from a long option. Of course, the trader does not have to go into a losing position. But if they do, they can mitigate the damage.

Much like vertical credit spreads, debit spreads too are aimed at safeguarding traders against bigger losses.

However, the two differ in some ways:

  • In credit spreads, the premium excess is “credited” whereas, in a debit spread, it is “debited.”
  • Credit spreads work in periods of both low and high volatility (implied). Whereas debit spreads only work well in times of low volatility.
  • For credit spreads, the potential loss can be greater than the premium collected. But for debit spreads, the loss can’t exceed the premium paid.
  • Traders using credit spreads can benefit from time decay while the opposite is true for those using debit spreads.

One isn’t necessarily better than the other, they both offer utility in different ways.

Selling Credit Spreads for Consistent Income

Even if the market moves opposite to what you expected, you can make a profit via credit spreads. Most consider 0.30 as the best delta for credit spreads — this is when it would make the most sense to execute such a strategy.

Delta can be seen on the trading charts as a curve, and you make can make your trading decisions based on the current reading.

If you’re day trading credit spreads, you must enter and execute the spread and close it just as you opened it.

Hopefully, this clears up: “What are credit spreads options?”

The Best Stocks for Credit Spreads Trading

Now that you have a basic understanding of “How do credit spreads work,” let’s explore the best stocks for put credit spreads.

Here are our top picks:

  • Apple
  • Facebook
  • Netflix
  • Amazon
  • Google

All these have a narrow bid/ask spread and high liquidity, making them ideal for selling put credit spreads.

What Are Credit Spreads Options and How Do They Work?

To sum up, the idea of selling credit spreads for income is buying a lower premium option than the one you’re about to sell in the same category. The difference in premium will be credited to you when you sell. If things go south, you can minimize your loss this way.

Using option credit spreads for income is not only practical but also very common.

If you do things right, you can use put credit spreads for income consistently!

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