Credit Spread Definition

Credit Spread noun: A structured stock option trade where one option is sold and another similar option in the same expiration period, further from the money is bought.

To understand what a credit spread is, let’s look at an example. With XYZ stock trading at 100, I sell a put option with a strike of 90 that expires in two months. At the same time, I buy a put option with a strike of 85 that expires at the same time.

For the 90 Put, I receive $10/share in premium. For the 85 Put, I have to pay $9/share. Then net result is for the pair of options, I receive $1/share. If I trade on pair of options, that controls 100 shares, so the net premium that I receive is $100.

If XYZ stock price stays above 90 for the next two months, both of those options will expire worthless. That $100 is mine to keep. If, on the other hand, XYZ plummets to 40, I will lose money on the 90 Put, but I will make money on the 85 Put that I bought. The net result will be that I will lose $5/share on the pair of options, but still get to keep the $1/share in net premium. So my maximum loss would be $400.

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