If you are new to options trading, you have probably heard people talk about credit spreads. They are one of the most popular strategies because they let you make money while limiting your risk. In this guide, we will explain what credit spreads are in simple terms.
What is a Credit Spread?
A credit spread is an options trade where you sell one option and buy another option at the same time. You get paid money upfront (the "credit") when you open the trade. Your goal is to keep that money when the options expire worthless.
The simple version: You collect money now and hope the stock stays in your favor. If it does, you keep the money. If it does not, you lose money (but your loss is limited).
The Two Types of Credit Spreads
1. Put Credit Spread (Bull Put Spread)
You use this when you think the stock will stay the same or go up. You sell a put option at a higher strike price and buy a put option at a lower strike price.
Example
Stock ABC is trading at $100. You think it will stay above $95.
- Sell the $95 put for $2.00
- Buy the $90 put for $0.50
- You collect $1.50 credit ($150 per contract)
If the stock stays above $95, both options expire worthless and you keep the $150.
2. Call Credit Spread (Bear Call Spread)
You use this when you think the stock will stay the same or go down. You sell a call option at a lower strike price and buy a call option at a higher strike price.
Example
Stock ABC is trading at $100. You think it will stay below $105.
- Sell the $105 call for $2.00
- Buy the $110 call for $0.50
- You collect $1.50 credit ($150 per contract)
If the stock stays below $105, both options expire worthless and you keep the $150.
Why Traders Like Credit Spreads
- Limited risk: You know your maximum loss before you enter the trade
- Time works for you: Options lose value over time, which helps credit spread sellers
- High win rate: You can profit even if the stock moves against you a little bit
- Less capital needed: Spreads require less money than selling naked options
The Risks You Should Know
Credit spreads are not free money. Here are the risks:
- If the stock moves past your short strike, you will lose money
- Your maximum loss is the width of the spread minus the credit you received
- Big sudden moves can hurt you before you have time to react
How to Calculate Your Risk and Reward
Let us use the put credit spread example from earlier:
- Credit received: $1.50 per share ($150 per contract)
- Spread width: $5.00 ($95 minus $90)
- Maximum loss: $5.00 minus $1.50 = $3.50 per share ($350 per contract)
- Maximum profit: $1.50 per share ($150 per contract)
Tips for Beginners
- Start small: Trade one contract until you understand how spreads work
- Pick high probability setups: Choose strikes that have a 70% or higher chance of expiring worthless
- Set a stop loss: Close the trade if it reaches 2x your credit received
- Track your trades: Keep a record of every trade so you can learn from your wins and losses
Track Your Credit Spread Trades
Pro Trader Dashboard automatically tracks all your options trades, including credit spreads. See your win rate, average profit, and which strategies work best for you.
Summary
Credit spreads are a great way to start trading options with defined risk. You collect money upfront and profit when the stock stays on your side. Start with small positions, track your trades, and learn from each one.
Ready to learn more? Check out our guide on iron condors or learn about put options.