Hey everyone and welcome to the credit spreads video tutorial here at Option Alpha.
And what I wanted to do in this video tutorial is go over what a credit spread is, and how
we use them in particular, here at Option Alpha.
Now, we use them a little bit different.
We sell credit spreads here, and we collect a premium upfront and hope that the options
decay in value over time.
And then we get to keep that premium.
So, this is a little bit different type of strategy, but it is by far, the most successful
strategy that we do have here at Option Alpha.
Now, here is a payoff diagram of a typical credit spread.
And this can go either way, but I just wanted to go over this diagram for you here.
And you can see that here is your profit lost line that is going up and down here.
And then you have the stock price at expiration which is this horizontal line here.
And here, you can see that this is a stock price value of 40, a value of 42, and a value
of 45 for this particular example.
Now, you can see at expiration, for example, if the stock was trading at $40 for this particular
credit spread, then you would lose about $200.
And the same thing goes with anything below 40 as well.
If the stock closes anything below 40, then you would still lose your $200 and no more.
Now, if the stock closed at 42, in this particular instance, you would make no money, but you'd
also lose no money on this trade.
So, you'd get back nothing on your investment.
If the stock trades at 45 or higher, then you make $300 and no more than that.
So, if the stock traded up to 60 or 70, you would still make your $300 profit.
So now, how we use credit spreads here at Option Alpha is a little bit different, like
I said.
We actually are selling credit spreads, and we want to sell credit spreads far from the
current market price and let the market move as it does, and we want to stay away and let
those options expire, giving us that credit which you see here, that $300 credit or $200
credit, at expiration as a premium that we keep in our portfolio.
So, here's a quick chart of a general stock that we just picked out, no dates, no times,
no stock that you're looking at.
And our strategy for the credit spreads portfolio would be to do one of two things: To either
build a credit spread below the market or to build a credit spread above the market.
Now, in either case, the market can move a little bit higher, a little bit lower.
It can even trade sideways.
So, it's a great market neutral strategy that we have here.
So long as the market doesn't go beyond our strike prices that we've built, either higher
or lower than the market, then we get to keep all of our money.
For example: If we were to build a credit spread below the market, we would then sell
a put at let's say, a strike price of 40.
So, that's the first leg of the credit spread.
It's to sell a put at a strike price of say, 40, and then buy another put at a strike price
of 39.
So, what's going to happen is that so long as the market, or this stock, or ETF trades
above that $40 level, then we get to keep our entire premium that we collected on that
trade.
Now, if we were to enter a spread above the market, it would look something like this.
We would sell a call at a strike price of 50, and buy a call at a strike price of 51.
And again, the same thing happens in reverse.
So long as the market trades below our strike price at 50, then we get to keep all of our
money that we have.
Now, the natural question that most people ask is what happens if the market trades beyond
that level.
The market trades beyond that level with credit spreads; then you just lose the money that
you had put up for margin.
So in this case, we would always disclose what we're going to be putting up for margin,
and that would be our max investment.
For example: If the stock were to get bought out, or the market would've crashed, or something
dramatic were to happen in a short period, that's the only way that we can lose money
on credit spread trading.
So again, I hope this video tutorial has been helpful to you guys.
And as always, if you have any questions, please email us or contact us.