Vertical credit spreads are among more common multi-leg trades that InvestorsObserver offers. Spread trades since they use two or more option legs to create a single positions, typically have defined maximum returns, while requiring the trader to risk much less capital than you would find in a stock position or covered call.
All of the spread strategies at InvestorsObserver involve buying one option, and then selling another option. In the case of vertical credit spreads, both options will have the same expiration date, and the option we sell will have a higher price than the option we buy. The shared expiration dates are what makes this a vertical spread, while collecting more from our sold leg than we pay to acquire the bought leg, is why this is a credit spread, as opposed to a debit spread.
In the bullish version of this trade, a bull-put credit spread, the investor sells an out-of-the-money put at one strike price and purchases another put further out of the money with the same expiration for a net credit on the trade. The bearish version of this trade, a bear-call credit spread, does the exact same thing, except it uses out-of-the-money calls.
The maximum amount at risk for a credit spread is the difference between the two strike prices minus the original credit.
If both options are out of the money at expiration, they will expire worthless. In this case, worthless is good, as the options just go away and you keep your initial credit.
The worst case for a vertical credit spread is if both options are in the money at expiration. This scenario will trigger the maximum loss, which is the difference in strike prices, less the initial credit.
In between these two cases is a middle path that happens only when the underlying stock finishes at expiration between the strike prices of the two options. In this case, the sold option is assigned is assigned, but the bought put expires worthless. This results in either a long, or short stock position that drastically changes the capital requirements and potential risks of the position.
Our analysts suggest that traders start looking for the a graceful exit for these positions as soon as it starts to look likely that it will not result in a full profit.