The credit spread is an advance option strategy which requires a level 4 approval from your broker. The credit has a lot of similarities to the debit spread in that it is a combination trade of buying (buy to open) and selling (sell to open) an option at the same time of differing strike prices but same expiration. A credit spread can be done with calls or puts. A credit spread with calls is bearish and is referred to as a bear call spread. A credit spread with puts is bullish and is referred to as a bull put spread. The net effect of the buying and selling options is a credit to your account. You receive money. If you end up spending money, it is a debit spread which is exact opposite of the credit spread as far as outcome.
There are pros and cons with this strategy that are the same as a debit spread. Some reasons for doing credit spreads are to reduce the cost or risk of entering into an option trade, to reduce the daily price fluctuations of option trades, and it requires less movement of the underlying stock.
Some of the cons would be that you have a cap on your potential gain, a big move in your favor won’t necessarily result in an immediate benefit, and typically you have to stay in a trade until option expiration to reach your cap.
With a credit spread, you want both options to be out of the money at expiration time, which means they expire worthless. This will give you your cap or maximum gain. The amount of money received when entering the trade is your maximum gain. In order to calculate your maximum loss, take the difference in strike prices x 100 (100 shares to a contract or 10 if a mini contract) x the number of contracts; from this amount, subtract out your money received when entering the trade. The result is your maximum loss. In order to make the credit spread trade, you will need to have an amount of money equal to the maximum loss of the trade in your account in case the trade goes against you.
You can close out of the trade at any time but typically plan on staying in the trade until expiration as long as it looks like both options will expire worthless. At expiration, options will expire and you will keep all the money initially received. If the options are in the money before expiration, you could have options exercised which would give you your maximum loss. However, most exercising won’t occur until expiration or close to it.
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