What are credit spreads?

Understanding Options Trading

Episode 08 – Credit Spreads

David McGann (00:17):

Hello to all of our viewers. My name is David McGann. I'm a director here at BMO InvestorLine and I'm thrilled to be co-hosting today's webinar on multi-leg strategies and specifically credit spreads. This comes to you as part of our webinar series that seeks to unpack options trading. Be sure to check out our education hub to find more webinars in this series that may be of interest to you. And once again today we'll be joined with our friends at OptionsPlay and I'm pleased to introduce Tony Zhang.

(00:43):

Tony is chief strategist at OptionsPlay, where he leads development of options trading products, education for investors, and oversees the firm's quantitative options research. He's a frequent contributor to CMBC for analysis on the markets with a specific lens using technical analysis, fundamentals and of course options. We're pleased to have Tony back. I know we have some great content to review today on credit spreads. And with that, Tony, I'll hand things over to you to kick us off.

Tony Zhang (01:12):

Thank you so much David, and thank you so much everyone for joining this today on our second series in the Multi-Leg trading series where we're focusing on vertical spreads. Today we're going to be talking about credit vertical spreads. Last time we covered debit vertical spreads. So we'll discuss, for everyone who may be not familiar, whatever one, what a credit spread is and more importantly, how they differ from debit spreads and what are the advantages to using these types of strategies depending on your specific outlooks here in the markets.

(01:45):

Now before we get started, what we are going to discuss here today is purely for education and demonstration purposes. It is not a solicitation or recommendation to buy or sell any of the specific securities that we may be using as example purposes during today's session. So what we're going to start off with is just helping introduce the concept of a credit spread, what it is, how is it constructed, and when you should consider utilizing it for those of you that may not be familiar with this specific strategy, and then what we're going to do to help you better understand them is look through two examples.

(02:22):

We're going to go through both a bearish example using a bear call spread, as well as a bullish example using a bull put spread to help you better understand these strategies, how they're constructed, the different specific outcomes of when they're expected to perform versus other strategies such as a debit spread. In the very end we'll do a review of trading credit spreads with a high level overview of when, how, and also specifically with regards to the trade management. But the primary thing that I want you to be able to walk away from today's session is a clear understanding as to how can you maximize your income in any market condition using credit vertical spreads.

(03:06):

That means regardless of what your views are, whether you're bullish, you're bearish, or even neutral on the markets, how can you maximize income using this one strategy? So to start off with, let's kind of break down what is a credit spread and their characteristics. So first of all, I think it's important to understand that credit spreads are an income generating strategy. These are strategies with what we call a slight directional bias. Now what that means is that you can generally use credit spreads in a lot of different market conditions.

(03:40):

They're either neutral to bullish or neutral to bearish, which means that regardless of what your views are, the markets, generally speaking, there is a credit spread that you could potentially trade to generate income based on your directional view in the broader markets. And it's specifically interesting because compared to other strategies, you don't necessarily need to have a strong directional view in order to utilize these types of strategies. Unlike long calls and long puts or even debit spreads that we covered recently, those strategies require you to have a fairly strong directional view before it makes sense to utilize some of those strategies because of the premium that you have to pay in order to acquire those types of strategies.

(04:25):

Vice versa, on a credit spread, because you're getting paid, you're generating income to sell a credit spread. You actually can take a fairly neutral view. So even if you don't believe a stock or ETF is going to move very much, you can find that those are optimal conditions to sell a credit spread. The second characteristic that I think is very important for investors to understand is the fact that these strategies have limited risk and limited reward. And that makes it suitable for a wide variety of investors because before you get into a credit spread, you know exactly how much money you can potentially make versus how much money you can potentially lose.

(05:05):

And you can choose a credit spread that fits your personalized risk tolerance to suit your needs with regards to the amount of risks that you're willing to take in the markets versus the potential reward you might be looking to capture relative to that risk. And this means that you can easily define that so that you don't have any scenarios where there are unforeseen circumstances with regards to risk on using a credit spread. And then lastly, I think really what attracts a lot of investors using credit spreads is the nature of its higher probability of profit relative to strategies like a debit spread.

(05:42):

If you compare a debit spread to a credit spread, credit spreads naturally have a higher probability of profit, especially when you select the specific strike prices in the examples that we'll go over during today's session. And also you layer on top of the fact that you don't need to necessarily have a large directional view, makes it a very versatile strategy for a lot of different market conditions. So to further better understand a credit spread, I think the best thing to do is actually go through an example and help you understand how it's constructed and the different components that make up a credit spread.

(06:19):

So in order to understand a credit spread, the first thing we actually need to do is to understand what we call the strategy driver of a credit spread. So we're going to start off by looking at a neutral to bearish example. So I'm going to use Apple as the stock in this particular case. Let's say in this particular example, Apple's trading around $200 and I have a neutral to bearish view. What that means is that I believe that Apple could potentially move lower or it might stay around where it's currently trading. I don't necessarily have a strong opinion as far as how far it's going to move lower, but I have a view that it's unlikely to move much higher from the current price of roughly $200.

(07:04):

And that's a good example of when you might utilize a strategy such as a short call or a credit spread. Now we're going to look at short calls first because this is how we're going to construct a credit spread. So let's say you have a neutral to bearish view here on Apple. So a single strategy that you could potentially take in this particular instance is to sell a call option. So in this example, let's say I was to sell an Apple call option at the $200 strike price, which is where it's currently trading. And let's say I'm able to collect $10 by selling that $200 call option. This means that what I'm able to do is to profit if the stock basically stays where it is or moves lower.

(07:50):

I'm going to sell at the money call option that expires roughly 45 days out and my potential reward is going to be limited to the premium that I collect in this particular case, $10. And my risk in this particular example is actually truly unlimited. Because if I were to sell a call option and the stock were to rise, the further the stock rises, the more I would lose on this strategy. And since there's theoretically no limit as far as how far a stock can rise, that's why this strategy has a truly unlimited risk nature. And when you look at the risk or reward of this particular strategy, on the surface it might look quite unfavorable.

(08:36):

You're effectively limiting your potential gains to $10 in exchange for unlimited lost potential. However, one of the trade-offs that you do have with this negative risk to reward ratio is the fact that the premium that you collect on the call option creates a buffer against the move that the stock can go against you before this strategy is unprofitable. So even though you have a neutral to bearish view on the stock, when you sell the call option because you're collecting premium for it, that premium acts as a buffer against the losses for the strategy. So in this particular case, you effectively have a $10 buffer for the stock to actually move higher before the strategy is actually unprofitable.

(09:26):

What that means is that even if you have a neutral to bearish view, and let's say the stock moves $5 higher from the time that you enter the trade to expiration, you are actually still going to be profitable. You effectively got the directional view wrong, but you're actually still profitable on the trade and that's the forgiving nature to some degree of an option selling strategy. And the more premium you collect, the bigger buffer that you have. So while on the surface, like I said, the risk to reward ratio may not look very attractive. The trade-off is actually quite interesting that you can effectively get the directional view wrong but still be profitable on the trade.

(10:07):

However, the one thing that I do want to keep reminding investors is the fact that this strategy truly has unlimited risk even though it has some very interesting trade-offs for that unlimited risk. For that very reason, this is a strategy by itself just selling the short call option naked is generally a strategy that we don't suggest many investors to trade. Especially since most investors actually may not necessarily even have the options level to sell a call option. Instead, what we advocate is to utilize a strategy such as a credit spread, which gives you a very similar risk to reward nature as you do with the short call with substantially less risk and without the same margin requirements that would be required to hold a naked short call option.

(10:56):

So that leads us to our next slide, which is how to actually construct that credit spread. So I'm going to use the same example. Apple stock is currently trading at $200. I have a neutral to bearish view on this specific stock. So what I'm going to do here to construct the credit spread is to do the exact same thing I did before in the previous slide. I'm going to sell the $200 call option for $10. However, instead of just doing that, what I'm also going to do in addition to that is I'm going to buy a call option that's higher in price. Let's say I buy a 220 call option and let's say I pay roughly $3 for that call option.

(11:37):

That means now my net credit for the two legs is going to be a net credit of $7. I collect $10 by selling the 200 strike and I'm going to pay $3 to buy the 220 call option. And the net credit on that is going to be $7. So what you're going to see here is that your view on the stock remains the same. You have a neutral to bearish view. You're going to establish a bear call spread in this particular example by selling the 200 strike and buying the 220 strike. And in this particular case, instead of collecting $10 as my maximum profit on the trade, I'm now only going to collect $7 on my maximum reward for this particular trade.

(12:21):

So I'm giving away effectively $3 of potential reward, but what I'm gaining from it is I'm now going to limit my losses on this trade. I'm actually going to limit my losses to the difference between the two strike prices, which is 200 versus 220. That's a $20 difference minus the $7 that I collect. So effectively I'm now limiting my losses to $13 in exchange for reducing my overall reward by just $3. So in the previous example, if I just sold the call option, I can potentially make 10, but my risk is truly unlimited. Now what I've done is I've given up $3 of potential reward by capping my risk to just $13.

(13:07):

Not only is that going to reduce your overall risk substantially on the trade, but it's also going to reduce the amount of margin that's required to hold onto a credit spread versus the margin required to hold onto a short call which can run you thousands of dollars versus here in this call spread, in the vertical spread because my risk is only $13 multiplied by a hundred shares. That's $1,300 worth of risk per contract. So I'm significantly reducing my risk in exchange for reducing my overall potential reward by, in this particular case, roughly $3.

(13:42):

So that is in nature how you construct a credit spread compared to such as a short call. And I think that we always use the example of a short call because the short call is a strategy driver. That is largely what is going to be contributing to gains and losses for this specific strategy. The long call that you're buying is really there as a component to reduce the overall risk of the short call option. But the nature of the strategy, the characteristic of this strategy is that you would be able to profit from this specific trade, even if Apple were to stay where it is, move lower or even if it moves a little bit higher, you'll still be profitable.

(14:25):

And to help you understand that, we've put together a chart to help you compare trading a debit spread versus a credit spread when you have a bearish outlook on a specific stock like Apple to help you compare the two strategies side by side and see how these two strategies perform based on different outlooks. So we're going to use the example just like we did before, Apple's currently trading at $200 and we have a bearish outlook on the stock. So what I'm going to look at is I'm going to buy a debit spread, which is a strategy we covered previously by going out to the buying the 200 by 180 bear put spread, paying roughly $7 for that debit spread.

(15:09):

Comparing that to the bear call spread that we just constructed in the previous slide where we sold the $200 call option and bought the $220 call option and received a net credit of $7. So what we want to do is we want to compare what happens if the stock moves in the direction we expect it to, what happens if the stock doesn't move at all, and what happens if the stock moves in the opposite direction that we expect it to? What are the different outcomes and what are the differences between a debit spread versus a credit spread? So let's start with the example of the stock moves in the direction that we expect it to. Right?

(15:50):

So if you were to sell a credit spread, let's actually look at the debit spread first. If you bought the 200 by 180 bear put spread, the debit spread and the stock moves down to 180. In this particular case in the debit spread, you paid $7 for that debit spread. And because it's a $20 wide debit spread, the difference between the width minus what you paid is going to be your potential maximum reward. So $1,300 is going to be your reward if the stock reaches that $180 short strike of your debit spread. So you basically risk $700 to potentially make $1,300 in the debit spread. So if you get the directional view right, you get paid nearly a 200% return on your capital that you risk with a debit spread.

(16:44):

And that's one of the, I would say, benefits of a debit spread is that if you get the directional view correct, especially if you get the magnitude right, you can have a pretty high return on capital with the debit spread. Now let's look at a credit spread. If the directional view is correct and the stock moves down to $180, you collect the $7 net premium on the credit spread. Whatever you collect, that's going to be your maximum reward. And that's what happens if the stock does move in the direction you expect it to. You keep the $700 of premium that you collected as your potential reward on this specific trade.

(17:23):

So your return on the strategy is not as high as the debit spread, but you are profitable in both cases if the trade goes in the direction that you expect it to. Now in the second scenario, this is where things get a little interesting. Let's say you have a bearish outlook on the stock, but by the time expiration comes around, the stock hasn't moved very much. Maybe it moved a little bit lower, but then it moved back to 200 or moved a little bit higher and came back down to 200. But basically at expiration, the stock is largely unchanged from when you enter the trade.

(18:01):

Well, we learned in the previous session when we looked at debit spreads that if a stock doesn't move in the direction that you expect it to for a debit spread, you largely will lose, if not the entire premium that you paid, a very large percentage of the premium that you paid depending on the strike prices that you've chosen. So if you bought a 200 by 180 debit put spread, and the stock doesn't move, you would effectively lose all $700 that you paid for that contract. Now, compare that to a credit spread where if, let's say, the stock doesn't move, this is what's really interesting about this specific strategy.

(18:39):

Because if the stock doesn't move, the $200 call option that you've sold expires worthless, the $220 call option that you purchase also expired worthless, which brings your net credit on the specific trade to be $700. So effectively you have the exact same profit potential with the stock not moving as the stock moving in the direction that you expect it to. So after you get into a specific trade, the stock can do many things, but in at least two of those instances, if the stock moves in the direction you expect it to or the stock doesn't move at all, you're going to actually capture the maximum profit potential of the credit spread strategy.

(19:22):

And that's really kind of the forgiving nature of this specific strategy. Now lastly, let's look at what happens if, let's say, the stock does not move in the direction we expect it to. It actually moves in the opposite direction we expect it to, so we're bearish on the stock, but let's say at expiration the stock is $20 higher at 220. Well, in a debit spread structure where we bought the 200 by 180 put spread, the most you can lose on a debit spread is the premium that you pay. So if you paid $700 on a debit spread, even if the stock goes to a thousand dollars, the most you'll lose is the $700 that you pay. And that's what happens with the debit spread.

(20:00):

But on a credit spread, what you can potentially lose is actually larger than what you collect in terms of premium. And remember we said that the vertical width in this particular case, which is $20 minus the $7 that you collect, the rest of it, the $13 is your maximum risk on this specific trade. So if the stock reaches 220, effectively what you've done is you've lost a thousand dollars on the short call, but you've also lost $300 on the call option that you paid the 220 call option. So your net loss in the trade is $1,300. So that is the trade-off that you're making with a credit spread.

(20:37):

Where in two out of the three possible scenarios, you'll be profitable. But in the one scenario where you're incorrect on the directional view and the stock moves in the opposite direction, you're actually going to risk more than what you can potentially make if the trade does go in the direction you expect it to. And then on the debit spread structure, it's sort of the exact opposite. In two out of the three possible scenarios, you will lose the full investment in the premium that you pay, the $700. But if you get the directional view correct and the stock makes a sizable move in the direction that you expect it to, you can potentially make more than what you have put at risk.

(21:17):

So one strategy is not better than the other, it's more of a decision that you have to make based on your outlook. So if you have a strong directional view and you feel pretty confident that the staff will make a big directional move in one direction or another, that's when a debit spread structure might make sense. Conversely, let's say, you don't have a strong conviction of a big move on the stock but you're fairly confident that the stock is not going to move significantly higher, significantly lower. That's really where the credit spread could potentially be beneficial because in two out of the three possible scenarios, you can potentially make the full maximum profit potential on the trade.

David McGann (22:00):

Tony, this is great. I'm going to jump in here. I've got a couple of questions for you if you don't mind. But I think you've done an excellent job really with this slide in particular to kind of examine some of the nuances and differences between a bear put spread and a bear call spread for exactly the same underlying and the same strikes. I guess maybe question number one, more of a general one, Tony.

(22:25):

I think one of the questions we get the most is what is the difference between a credit spread and a debit spread? And so if you were to really, in simple terms, try to help our audience just understand some of the key differences, how would you describe that? That's question number one.

Tony Zhang (22:48):

That's a really great question and I think this is probably a question that I also get fielded quite a bit. And a lot of traders try to compare debit spreads to credit spreads to decide which one is better suited for them. And I think the chart that we have up here really helps you better understand the strategies in nature. I think the best way to think about it is that any type of debit spread, you're paying a premium. So that means that whatever directional view that you have in the markets, the stock effectively has to move by that premium amount in order for it to justify buying that debit spread.

(23:26):

So you only really think about using debit spreads when you are expecting the stock to make a sizable move in one direction or another, and you get a really nice risk or reward when you do get that directional view correct. Otherwise, if you don't get the directional view right or the stock doesn't move, you'll see near a hundred percent loss in the premium that you've paid on the debit spread. And conversely, on a credit spread, it's sort of the exact opposite. You're going to get paid premium to sell a credit spread, and that's going to create a buffer against the directional view that you expect it to move.

(24:02):

So if the stock moves in the directional view you expect it to, you get maximum profit potential. If the stock doesn't move, you can potentially still have maximum profit potential. And even in many instances, the stock moves slightly against you, you can actually still be profitable. It's an extremely forgiving strategy. In many different scenarios, you'll see profits. It's a much higher probability of profit strategy. But the trade-off with the higher probability of profit strategy is the fact that what you lose if the trade goes in the direction you expect it to is going to exceed what you can potentially make on the strategy if you do get the directional view correct.

(24:42):

So like I said, one strategy really isn't better than the other. It's really more of a spectrum of when you think about debit versus credit spreads or any option strategy, what you're trading off is probability with risk to reward. You can either have high probability with relatively poor risk to reward. Or vice versa, a very strong risk or reward, but relatively poor probability of profit. And what you have to determine is really where you want to sit on that spectrum. Like I said, one is not better than the other, and it's just a matter of understanding the characteristics of each of these strategies and where they sit on that spectrum.

(25:21):

And you can decide what suits you depending on your market outlook.

David McGann (25:26):

Thank you, Tony. So I've got one more that I'm going to fire at you if you don't mind, because I think this is a great point to talk through. If you could go back a slide, if you don't mind, Tony, and we could just take a look at that slide one more time. And so I think great explanation on some of the fundamental differences between credit spread and debit spread. And you might recall when we did the debit spread webinar and for our audience members, if you haven't had a chance to check out that webinar, highly encourage you to go and do that.

(25:57):

But when we were doing some of these comparisons, we were actually comparing a standard kind of long call or a long short with a debit spread, either a bullish or bearish debit spread. And so when we were looking at the different scenarios in terms of what the profitability would look like at various different prices at expiration. It was pretty glaringly clear that in a lot of instances the debit spread actually could be a smarter play than just going with a standard long call or a long put.

(26:33):

What's interesting about this view as we compare a bear put spread with a bear call spread is it's kind of a mixed bag. You see a bit of red and green across the board. And so I guess where I'm going with my next question for our audience, especially for those that might be newer to vertical spreads, newer to debit spreads, newer to credit spreads, how might you guide them? Would you encourage them to think about maybe trying to learn one of those strategies and kind of sticking with that and finding, I guess, an investment environment that bodes well for a credit spread, for example?

(27:15):

Or do you encourage them to dabble with both? I'm just curious on how you might guide our audience. Should they always be thinking about the pros and cons and the trade-offs of a credit spread versus a debit spread? Or if they're just getting started, should they actually just focus on, "All right, I want to learn the ins and outs of the debit spreads. I want to really understand that. First, have some success with that and then start to layer in potentially credit spreads on top of that." So just curious in your experience how you might guide our audience to think about that.

Tony Zhang (27:48):

Thank you so much, David. I think that's a fantastic question. So if you think about the nature of these two strategies, the debit spread is really suited for when you expect the stock to make a fairly sizable move and credit spreads can be used in a lot more different outcomes. Just from that perspective alone, you tend to find that credit spreads are far more versatile strategy. So I actually encourage a lot of investors to spend more time at the credit spreads first simply because you're going to find a lot more opportunities to potentially deploy that strategy.

(28:20):

Versus debit spreads, you're just naturally going to have fewer opportunities where you feel a stock is going to make a very sizable move. Higher or lower, right? That could be earnings that are coming up, maybe a product launch or some type of catalyst where you believe the stock could make a big move. For those instances, that's when you want to explore a debit spread. But you're going to have far more instances where you may not necessarily feel that the stocks are going to make a big move in one direction or another, and that's really where credit spreads are going to be far more suitable.

(28:53):

So just on that alone, I tend to find a lot of investors spend more time exploring credit spreads first because they can find more opportunities to deploy it. And then in the instances when they do find maybe earnings are coming up or macroeconomic event is going to come up and they believe that the stock could make a big move, that's when you want to explore a debit spread.

David McGann (29:15):

Excellent. That's great, Tony. Thanks for taking the time to answer that question.

Tony Zhang (29:20):

Not a problem, David. Happy to help. So let's take a look at the strategy selection because we've talked a little bit about this specific strategy, but I want to just help better understand this at a deeper level from... We talked about the fact that you might want to sell a bear call spread, a bearish credit spread when you have a neutral to bearish view. But I also want to dig a little deeper here in that because this is a strategy that effectively profits from when relatively premiums are high, meaning the premium that you collect on selling that option is relatively high.

(29:56):

So the buffer or the income that you collect on it is relatively high, and what you are expecting is that the stock is either going to stay put or move lower. So this could be because you believe the stock is generally near a resistance level or it's overbought conditions and you believe it's now going to turn lower. These are all potential opportunities to consider selling a credit spread or selling a bear call spread in this particular example. And the other thing to understand is that this is a strategy that, generally speaking, favors high implied volatility environments.

(30:33):

So when the markets are more volatile, when implied volatility is high, that's really where this strategy tends to perform better because the premium that you collect on that short leg will be elevated and you're going to be able to collect a little bit more premium, which means that you're going to have a slightly better risk or reward ratio on that credit spread when implied volatilities are higher. With that, let's now move on to looking at bullish strategies. Now, I spent a lot of time walking through that bearish strategy. Now when we look at bullish strategies, it's really just a mirror image.

(31:11):

So if you already feel that you've got a pretty good grasp on that bearish trade, you're going to find the bullish trade fairly easy to grasp. But if you feel that you're still working through understanding these strategies, hopefully by looking at another example here where we're exploring bullish strategies, it'll help you solidify your understanding. So now let's take a look at Apple, the same $200 stock, where Apple's trading at 200. And in this particular instance, we are either neutral to bullish on the specific stock. Which basically translates to, "I feel that $200 on Apple is a pretty strong support and I don't believe it's going to move materially low or below 200."

(31:53):

That's another way to think about when you have a neutral to bullish view on a specific stock. So when you have that view that you believe that Apple is near a floor and you don't believe it's going to move much lower below that level, well one strategy that you might want to deploy when you're limited to trading a single leg is selling a short put. So in this example, let's say I sell an Apple $200 put option, and let's say I collect $10 for that put option. That means I'm going to establish a net credit of this particular trade at $10. Now let's say I sell a 45 day at the money put for $10, the premium that I collect, the $10 that I collect is going to be my maximum reward.