Options trading is an advantageous way to make money in the stock market, but like any other strategy, it involves risk, and there are many different strategies available. One such strategy is Vertical spreads, including a bullish spread and bearish spread.
These include purchasing one call option at a lower strike price and selling another call option with the same expiration date and at a higher strike price with the same expiration date. The primary difference between vertical spreads and credit spreads is that there is no initial cash payment for vertical spreads, while credit spreads require an initial outlay known as the ‘credit’.
What is a credit spread?
The most basic equation for calculating maximum profit for a bull put spread or bear call spread (the two components of a vertical spread) is: Max Profit = Strike Price of Short Call- Strike Price of Long Call-Net Premium Received
A vertical spread is constructed with the same expiration date for both options. A credit spread involves an initial outlay but has a higher return potential. The most basic equation for calculating maximum profit for a bull put spread or bear call spread (the two components of a credit spread) is: Max Profit = Strike Price of Short Put – Credit Received + Strike Price of Long Put – Net Premium Paid
Max Loss = Total Premium Paid – Maximum Profit
In this equation, the total premium paid refers to the total amount paid to establish the position and can be calculated as follows: Total Premium Paid = Initial Margin + Maintenance Margin.
Initial Margin is calculated as Initial Margin = 100% *(Short Put Strike Price + Short Put Premium Paid)
Maintenance Margin is calculated as Maintenance margin = 100% * (Short Put Strike Price – Long Put Strike Price)
What is a vertical spread?
The intrinsic value of the options contracts changes along with underlying stock prices. If options are allowed to expire, the loss incurred by vertical spread strategies increases over time. Credit spreads, however, do not incur any losses until the short position expires worthless.
Here is an example of a vertical spread: buying one put with a strike price of $1 and selling another put with a strike price of $2. This will be done simultaneously, thus creating the classic “vertical” spread.
You can also buy (go long) the first option and sell (go short) the second option, and both options have the same expiry date but different strike prices. The investor/trader seeks for this difference between the two strikes to widen significantly up to expiry, thereby allowing them to pocket cheap premiums. If that happens then, everything works out well for this position.
If that fails, however, one has created a credit spread which would mean taking on more risk than initially planned – since what was sold may have to be repurchased at a higher price than expected.
Differences between a credit spread and a vertical spread
A credit spread is the same “structure” as a vertical spread except that we take in / collect premiums from what we sold and don’t pay anything to buy the second option.
This creates an asymmetry between risk and reward: if both options expire in the money, then one way or another, we lose money – this means that there is zero return on investment (ROI). If both options expire out-of-the-money, however, then again, one way or another, you lose – but although it may seem like losing twice, you still end up with some money in your pocket.
Both vertical and credit spreads are types of options trading strategies that an investor can use to create a neutral or limited risk trade. Beginner traders interested in Singaporean options trading are advised to use a reputable online broker from Saxo Bank and trade on a demo account before investing real money.