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Credit Spreads

All About Credit Spreads - Definition, An Example, and How to Use

A credit spread comes about when you purchase one option and simultaneously sell an option (for the same underlying security, of course), and you end up with cash in your account.  In a credit spread, the amount that you collect by selling an option is greater than the amount you have to pay for the option that you buy.   

In a typical credit spread, you are hoping that both sides of your credit spread (i.e., the long option you bought and the short option you sold) will expire worthless, and you will be able to pocket all the cash you collected when you first sold the credit spread.

Just in case you are so lucky, and both options in your credit spread do not expire worthless, the broker will charge you a maintenance requirement which is equal to the maximum possible loss you could experience with your credit spread.  Usually, that works out to be the difference between the strike prices of the long and short option.  The maintenance requirement (i.e., the maximum loss possible) is reduced by the amount of cash you collect from the credit spread when you first placed it.

In similar fashion to all spreads, credit spreads are purchased to reduce risk.  The other side of the coin is that your maximum gain is limited. 

There are two greats feature of credit spreads.  First, if either or both of the options expire worthless, there is no commission to pay when the options expire.  Second, if you are trading in an account in which you have a margin loan on stock, the money you collect from the credit spread will offset some or all of the margin loan, and you will not pay interest.

An interesting side-note: If you sell stock short in a margin account, the cash is not generally applied to a margin loan.  Only cash received from the sale of an option credit spread will offset a margin loan.

 

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