Explore Your Options by Price Headley
ABOUT CREDIT SPREADS
How does a credit spread work?
There are several types of spreads, but
they all work similarly. Option spreads
can be used to take a bearish, bullish,
or neutral position. For example, letís
look at a credit spread, which is what a
spread is called when it generates a net
inflow of cash into your account.
In this instance, we are bearish; according
to our calculations, we think the
price of XYZ stock will go down. We
decide to sell a September 30 call for a
price of $3. Since we think that XYZ
will go down in price, we assume that
nobody will want to exercise our short call against us ó that is, make us sell
them XYZ shares at $30 ó since they
can be bought in the open market for
less than $30.
However, to protect ourselves in case
we are wrong (in case XYZ shares increase
in value), we buy a September 35
call at a price of $1. That way, if XYZ
shares go to $40, we can get someone
else to sell their shares to us at $35, and
we can cap our risk at the $5 difference.
Our real maximum risk is the $5 difference
minus the credit collected. Take a
look at our position in Figure 1.