Bear Credit Spread Explained

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Contents

Credit Spreads: Explained

Anyone who goes on an introductory course in options trading will no doubt become familiar with credit spreads. This remains one of the most popular trading strategies among traders of all levels for a variety of reasons.

Definition
A credit spread is an options trading spread for which the trader does not have to pay an upfront fee. Instead the trader is actually paid to set up a credit spread! The reason for this is that credit spreads involve selling more expensive options and buying cheaper ones, which means the net premium results in a credit to the trader’s account.

Margin and trading Level

There is a trade-off though: whereas a debit spread does not involve any margin, since the trade can usually not lose more than the net cost to set up the position, a credit spread sometimes has the potential to lose an unlimited amount of money. This results in broker requiring a margin deposit before a trader can set up a debit spread. For stock options a higher trading level is usually also required than for debit spreads.

Benefits of credit spreads

Whereas most debit spreads require the price of the underlying asset to move either up or down in order to profit, credit spreads have the unique ability to profit if the price of the underlying asset remains stagnant or moves in a narrow range.

Although some credit spreads have unlimited potential for loss, there are also many other credit spreads with a limited potential for loss.

While credit spreads require a margin deposit, they still require a smaller margin deposit than naked puts or naked calls. In fact the lower margin involved is one of the reasons why many traders prefer credit spreads over selling naked options.

Although most credit spreads will profit in a stagnant or range-trading market, there are also credit spreads that will profit if the market breaks out either to the upside or the downside.

A credit spread for bullish markets

Below is an example of a typical bullish credit spread, the bull put spread. This involves selling ATM put options and simultaneously buying OTM put options for the same expiration date.

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A credit spread for bearish markets

Below is an example of a credit spread for a bearish market. The bear call is set up by selling ATM call options and simultaneously buying the same number of OTM call options for the same expiration date.

A credit spread for neutral markets

If a trader believes the market will remain either stagnant or range-bound until the expiration date he or she can’t do much better than a credit spread specifically intended for neutral markets. One such example is the very popular iron condor, which consists of selling OTM calls and OTM puts while simultaneously buying further OTM calls and puts which are cheaper.

Fig. 9.28(d) is an example of a typical iron condor credit spread.

A credit spread for volatile markets

If it is highly likely that the price of the underlying asset will break out either to the upside or the downside, a trader should opt for a credit spread designed specifically to benefit from this situation. An example in this regard is the ever popular short butterfly spread that is illustrated below in Fig. 9.28(e).

This trade is set up by buying two ATM call options and simultaneously selling an OTM call and an ITM call. The higher premium income from the ITM call helps to more than offset the cost of the ATM calls, creating a net credit.

While credit spreads can be ideal under certain circumstances, one always has to take into account a) the probability of the trade actually realising a profit and b) whether the maximum risk/maximum profit payoff justifies the trade.

Option Spreads – Debit Spreads versus Credit Spreads Explained – Debit Spread and Credit Spread Examples

Safe Combination of Making Money

Many traders will never trade stock options because they believe it’s almost certain they will lose their money. This is true because a stock options changes price so fast it’s like fire next to propane – before you realize what is happening you have already lost the better part of your money you used to buy the stock options. But if you combine a long option with a short option you create a safe combination of making money from the stock market.

But first, some definitions:

A call option is a contract that gives the holder the right to buy 100 shares of stock from the writer of the option contact at the strike price within up to a specified period of time up to the expiration day. The one who writes the option contact is “short” the call option. The one who buy the call contract is “long” the call contract.

A put option is a contract that gives the holder the right to sell 100 shares of stock from the writer of put option at the strike price within a specified period of time up to the expiration day. The one who writes the put option contact is “short” the put option. The one who buy the put contract is “long” the put contract.

Option Spreads – What Is Debit Spread?

When an option trader buy an option and at the same time sells an option each with different strike price on the same underlying security, the difference between the prices of the two options is called a spread. If the option with the higher price is purchased and the option with the lower price is sold, the trader gets a debit which is the difference between the two prices. This is called a debit spread.

Example: An investor buys a call option for XYZ stock with a strike price of $90 for $3.00. Immediately the same investor sells a call option for XYZ stock with a strike price of $95 for $1.00. The debit spread is $2.00 which means the investor has actually invested out of pocket $2.00 x 100 equals $200. The investor will do this if he believes the price of the stock is to go higher and that the bought call option will gain more than the sold call option for the same price increase of the underlying stock. If he believes the underlying stock is to go down in price, then he will buy a put at a higher strike price and sell another put at a lower strike price.

Option Spreads – What Is Credit Spread?

When an option trader buy an option and at the same time sells an option each with different strike price on the same underlying security, the difference between the prices of the two options is called a spread. If the option with the higher price is sold and the option with the lower price is bought, the trader gets a credit which is the difference between the two prices. This is called a credit spread. However, the trader will have to provide cash collateral equal to the difference between the two strike prices. The cash collateral is called a margin.

Example: An investor sells a put option for XYZ stock with a strike price of $95 for $3.00. Immediately the same investor buys a call option for XYZ stock with a strike price of $90 for $1.00. The credit spread is $2.00 which means the investor has actually been credited with $2.00 x 100 equals $200. The investor will in addition have to provide cash collateral of $500 ((95-90)x100). The investor will do this if he believes the price of the stock is to go lower and that the sold call option will lose more than the bought call option for the same price decrease of the underlying stock. If he believes the underlying stock is to go up in price, then he will sell a put at a higher strike price and buy another put at a lower strike price.

1. When a stock is expected to go up in price, you can trade it with a debit spread of calls or a credit spread of put.

2. When a stock is expected to go down in price, you can trade it with a debit spread of puts or a credit spread of calls.

Debit Spreads Versus Credit Spreads – Which Is Better?

Which is better Debit Spreads or Credit Spreads? Many people want to tell us that there is no difference between a debit spread and credit spread, but there is a very great difference between Debit Spreads and Credit Spreads.

We are going to find out using a real life example. We are to use QQQQ Powershares options which are traded at very high volumes, they are liquid and chances of finding a miss-priced option are slim. QQQQ Powershares is an ETF which is as good as a stock.

Below are the QQQQ options prices based on the QQQQ closing price of $49.03 0n April 9 th 2020. We are to use options that are out of money to avoid the short leg of the option being exercised. As you will notice we have picked options for the month of June because they are more profitable as they are close to expiration date (but far enough to have sufficient time value to avoid early exercise).

The first table shows the debit spread using a long QQQQ call 50 for June and a short QQQQ call 52 for June. The price of the debit spread is $615 which is for 10 contracts.

In the second table, we have a credit spread using a short QQQQ put 50 for June and a long QQQQ put 47 for June. The price of the credit spread is $655 which is for 10 contracts.

It is assumed the cost of debit spread $615 and credit spread $655 are close to each other to allow for comparison. It is also assumed that the current implied volatility of the options will remain constant over the period of comparison.

1. after One Month

(A) Credit spread – if the price of QQQQ remains the same after one month, you gain 655-580 =+$75

(B) Debit spread – if the price of QQQQ remains the same after one month, you lose 615-435=-$180

(C) Question – Would you prefer a credit spread or a debit spread?

2. Price Increases Immediately

(A) Credit spread – if the price of QQQQ moves immediately for $1 gain in price, your credit spread will gain 655-485 = +$170

(B) Debit spread – if the price of QQQQ moves immediately for $1 gain in price, your debit spread will gain 870-615=+$255

(C) Question – Would you prefer a credit spread or a debit spread?

3. Price Decreases Immediately

(A) Credit spread – if the price of QQQQ moves immediately for $1 loss in price, your credit spread will lose 880-655=-$255

(B) Debit spread – if the price of QQQQ moves immediately for $1 loss in price, your debit spread will lose 615-385 = -$230

(C) Question – Would you prefer a credit spread or a debit spread?

4. Price Increases after a Month

(A) Credit Spread – if QQQQ moves for $1 gain in price after a month, your credit spread will gain 655-385 = +$270

(B) Debit Spread – if QQQQ moves for $1 gain in price after a month, your debit spread will gain 775-615 = +$160

(C) Question – Would you prefer a credit spread or a debit spread?

5. Price Decreases after a Month

(A) Credit Spread – if QQQQ moves for $1 loss in price after a month, your credit spread will lose 865-655=-$210

(B) Debit Spread – if QQQQ moves for $1 loss in price after a month, your debit spread will lose 615-200=-$400

(C) Question – Would you prefer a credit spread or a debit spread?

6. Cost of Putting the Spread

(A) Credit Spread – The cost of putting the spread is a credit of $655 and a margin of $2000 =-$1345

(B) Debit Spread – The cost of putting the debit spread is a debit of $615 =-$615

(C) Question – Would you prefer a credit spread or a debit spread?

Same Amount of Money Invested?

If we assume the margin is a cost because the stockbroker holds that money in such a way you can not use it, then it would be logical to assume our credit spread cost $1345 and our debit spread cost $615. To be fair to ourselves in this comparison, we need to compare a debit spread of 20 contracts in each leg to our credit spread of 10 contracts in each leg so that the amount of money invested in each case is almost the same.

We shall compare again using 10 contracts for credit spread and 20 contracts for debit spread, and in each scenario we shall allocate a total of 3 marks.

1. after One Month

(A) Credit spread – if the price of QQQQ remains the same after one month, you gain 655-580 =+$75

(B) Debit spread – if the price of QQQQ remains the same after one month, you lose 1230-870=-$360

(C) Remark. Allocate 3 marks to credit spread and 0 marks to debit spread

2. Price Increases Immediately

(A) Credit spread – if the price of QQQQ moves immediately for $1 gain in price, your credit spread will gain 655-485 = +$170

(B) Debit spread – if the price of QQQQ moves immediately for $1 gain in price, your debit spread will gain 1740-1230=+$510

(C) Remark. Allocate 0.5 marks to credit spread and 2.5 marks to debit spread

3. Price Decreases Immediately

(A) Credit spread – if the price of QQQQ moves immediately for $1 loss in price, your credit spread will lose 880-655=-$255

(B) Debit spread – if the price of QQQQ moves immediately for $1 loss in price, your debit spread will lose 1230-770 = -$460

(C) Remark. Allocate 2 marks to credit spread and 1 mark to debit spread

4. Price Increases after a Month

(A) Credit Spread – if QQQQ moves for $1 gain in price after a month, your credit spread will gain 655-385 = +$270

(B) Debit Spread – if QQQQ moves for $1 gain in price after a month, your debit spread will gain 1550-1230 = +$320

(C) Remark. Allocate 1.4 marks to credit spread and 1.6 marks to debit spread

5. Price Decreases after a Month

(A) Credit Spread – if QQQQ moves for $1 loss in price after a month, your credit spread will lose 865-655=-$210

(B) Debit Spread – if QQQQ moves for $1 loss in price after a month, your debit spread will lose 1230-400=-$800

(C) Remark. Allocate 2.5 marks to credit spread and 0.5 marks to debit spread

6. Cost of Putting the Spread

(A) Credit Spread – The cost of putting the spread is a credit of $655 and a margin of $2000 =-$1345

(B) Debit Spread – The cost of putting the debit spread is a debit of $1230 =-$1230

Would You Prefer A Credit Spread Or A Debit Spread?

The Big Question – Would you prefer a credit spread or a debit spread? The credit spread has scored 9.4 marks against 5.6 marks for the debit spread. This therefore means I would prefer a credit spread instead of a debit spread. The only thing I would have to worry most is for the short leg to get too much in the money to avoid early exercise. Ideally, if I invest, say $300, and it becomes $400, I will need to close the position and lock that profit of $100. I then start all over again with say $300. If you leave too much of your profit on the table, they will one day take it.

To small investors who may not be having much money to invest, they may prefer the debit spread. To successful investors who have large accounts with idle dollars, they may prefer the credit spreads. To trade using a credit spread or a debit spread should be a personal decision which will vary from one investor to the other. Trade using the strategy you feel comfortable trading with.

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Comments

monicamelendez

7 years ago from Salt Lake City

You’re so much smarter than me ngureco. :)

OptionsAddict

9 years ago from Near a Trading Screen

Good stuff, and well presented! If I had your patience, I would do the same, but I’m not there yet (LOL).

Hello, hello,

9 years ago from London, UK

A comprehensive information. Thank you.

msorensson

Well done! You were able to summarize about 6 books!!

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Credit Spread In Finance And Their Probability Distributions In Data Science

Using Python To Demonstrate Financial Credit Spreads And Hazard Rates

One of the famous areas in finance is about using and modeling credit spreads. Credit spreads are used every day by large financial institutions to price the transactions.

This is a special article that will explain the famous credit spread risk and will explain how data science can help there.

If an investor wants to take more risk then it is only natural for the investor to expect to gain higher return. You can invest your money in a local company and buy its corporate bond or you can invest in buying a government bond. Government bonds are less riskier than the local companies. The riskier the company, the higher the yield interest rate it would offer to attract you into buy its product.

Credit spread is the difference in yields between your target security such as a corporate bond and a reference security such as a government bond.

This article will explain what credit spread is, what hazard rates are and it will also explain the underlying probability distribution in detail.

  • I will start by explaining the financial concept.
  • Then I will provide an overview of how we can utilise the statistical measures that are widely used in the field of data science.

Scenario For The Article

This article will explain the concepts that revolve around this scenario:

Let’s assume you have £1000 to invest. You come across two securities with identical time to maturity. The first security is a high rated instrument such as a government bond and the second security is a corporate bond offered by your local high street bank. The government bond will be referred to as the benchmark security.

Spread is all about interest rates.

What Is Credit Spread?

Now the way plain vanilla bond works is that you lend your money for a period of time and you get timely payments in return. On the time of maturity, you get all of your original money back. The timely (monthly, semi-annually, annually) payments are based on the yield rate that the borrower offers. The borrower of the money is known as the issuer as it is issuing the bond.

Now you have considered the buy two bonds in the scenario above. Each of these financial institutions would offer the yield rates over a period of time.

If you were to plot the yield rates of a government bond and a corporate bond for a time then the difference between the two yields will be known as the credit spread.

  • It’s important to note that the maturity of both of the instruments is identical but the credit quality is different.
  • The credit spread is therefore the difference in risk premiums of the instruments with same maturity and different credit quality.

If you want to understand credit risk, read this article:

Risk Management: Understanding Credit Risk

This article serves as an overview of counterparty credit risk and outlines terminology used in credit risk management…

medium.com

What Are The Different Spread Measures?

There are a number of spread measures. I am going to briefly outline the common measures:

  1. Yield Spread: It is the difference between the yield to maturity of a risky and the benchmark bond. The maturities of the instruments is the same.
  2. i-Spread: The “i” refers to the mechanism of interpolation. It is the difference between the yield to maturity of a risky and linearly interpolated yield to maturity on the benchmark bond. It is calculated when the maturities of the instruments is not the same.
  3. z-Spread: The z-spread is constructed by adding the basis points on the spot rate of the benchmark curve to get the desired bond price.
  4. CDS Spread: This is the premium of CDS of issuer bond to protect from any of the credit events. CDS spreads are observable in market. Plus, liquid CDS contracts are available in market for a large number of maturities. Hence CDS spreads are commonly used.
  5. Option Adjusted Spread (OAS): If you take the z-Spread and adjust it for the optionality of the options then it becomes OAS.

What Is Spread’01 In Finance?

Spread’01 is known as DVCS.

We want to investigate how sensitive our bond is to the z-spread. We can do that by computing DVCS.

  1. The way it works is that the z-spread is shocked up by 0.5 basis points and the corporate bond is priced.
  2. Then the z-spread is shocked down by 0.5 basis points and the corporate bond is priced.
  3. The difference in the price tells you how sensitive the bond is to the z-spread by 1 basis point.
  4. This measure is known as Spread’01 or DVCS.

Spread’01 measures the credit spread sensitivity.

The marginal change in the spread ’01 decreases when the spread is increased.

It is very similar to DV01. Read this article to get a good understand of the DV01 Bond Risk concepts:

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