It has been well said that one of the most profitable skills you can ever learn is the art of trading. But when it comes to trading the stock market, there are many different strategies available to us. Some are very volatile, short term and high risk, while others are much more flexible, less stressful and don't rely so much on correct prediction of future price direction. The credit spread is among the latter. In this article, we will answer some common questions about credit spreads so that the reader can assess whether it suits their style of trading.

What is a Credit Spread?

A credit spread is an option trading strategy which is so named because it puts a credit into your broking account rather than taking a debit from it when you enter the position. In order to understand why this is so, you need to know a little about how option prices work.

Options have two main features - the 'strike price' and the 'expiry date'. The 'strike price' is the price of the underlying financial instrument such as a share, that you agree to either buy or sell it at, by a given date. The general rule is that the closer the strike price is to the current market price, the more expensive the option contract. The further away the strike price is, to the current share price, in line with the type of option you are trading (ie. call or put), the cheaper it is. This is called 'out of the money'.

So the idea is that you SELL (write) an option at a strike price which is closer to the current stock price, preferably 'at the money' and simultaneously BUY the same number of options at a strike price further away, or 'out of the money'. The SOLD option will be more valuable than the BOUGHT one, thus resulting in a credit to your account.

So you have a 'spread' in that your trade consist of both bought and sold positions at different strike prices - and you have a credit as explained above.

What Advantages Do Credit Spreads Provide?

Credit spreads provide a number of significant advantages, particularly in the area of risk. As such, they are not a 'day trading' type strategy, but more of a longer term approach. They usually take about 4-6 weeks to mature, but can be closed out before then. They can also be taken based on a view of either a future rise or fall in the share price.

During the term of the spread, the underlying share price can only move in one of 5 ways:

1. A small move upwards

2. A small move downwards

3. A side ways move - "goes practically nowhere" or returns to its original price by expiry date.

4. A large move upwards

5. A large move downwards

An option credit spread will make you a profit from 4 out of the above 5 possible price directions. That's 80 percent odds in your favour! How is this so? Because credit spreads take advantage of the time decay associated with options. If the share price is 'out of the money' by expiry date, you get to keep the full credit you received when the trade was taken out. Even if it is close to the money, even in the wrong direction, you will still make a profit due to time decay.

But what if the worst case scenario occurs and the share price makes a strong move against your anticipated direction? Here is where one of the main advantages of credit spreads comes into play. Because the main feature of your spread is a 'sold' position, you can do what is called 'rolling out' to a future month. Alternatively, you can also 'roll out and down (or up)'. You simply close out your original position and re-open it with next month's expiry date. If the share price has moved against you, you will receive a much larger credit this time, which will compensate for the loss on the previous one and then some.

What are the Best Setups for Credit Spreads?

Before you take out a credit spread, you should check a stock chart for price patterns. You want to enter at a time when a stock has moved significantly in one direction and is due for a reversal. One of the most common patterns that help you are are called channels. Draw a line along the highs and lows of a daily price chart and you may see a channel appear. If so, and there are no signs of weakness in the channel, you're onto a pretty good thing for a credit spread trade.

Is there Anything Else I Should Be Aware Of?

Yes. One final matter is an ingredient in option prices called the 'implied volatility' (IV). If you are able to enter a position where the sold option has a higher IV than your bought position, it will increase your credit and at the same time, diminish your risk even further.

Conclusion

Credit spreads are a low risk, sleep at night, style of option trading strategy. It is not for those who want to be in one day and out the next. It works it magic ideally over about a month. But the return on investment is still excellent and the lower risk makes it very appealing.