A credit spread includes selling and purchasing options on the same underlined futures contract and selling it at different strike prices. If you sell the option higher or closer to money than the option you purchase, this results in a net credit for the trade.
Options have a higher premium associated with them than further away options when they are closer to the money. If you sell an option closer to the money, you will collect more than what you have to pay for the acquired option. This ends in a net credit for your account.
Buying the option is essential to this trade because it is what gives you the defined risk.
Maximum Risk And Reward
One can calculate the maximum risk by taking the difference in the strike prices from the one they sold and the one they purchased. It is calculated in terms of what it could be if they had a futures contract.
What one collects for the spread is subtracted, providing them the full risk associated with the trade. The maximum reward associated with the trade is the net collection from when one initiates the trade. Commission and fees should always be included when figuring out the risk and reward.
Credit Spread Example
For instance, let’s say that you have been researching the crude oil market. You’ve taken a look at the fundamentals and technicals and decided that the March crude oil market will not go below 95.
Presently, it’s trading at 100, and you are comfortable initiating a 95/90 credit spread. That means you would be looking at a 95 put. If you sell at a price of $2,095, you’ll buy the 90 put.
Currently, you could buy it for $1,250. Here, the max reward would be $1,250 minus the fees and commissions. This means that the complete risk associated with the trade would be $3,750 plus the fees and commissions.