Definition: A credit spread option is an options strategy in which investors realize a profit by buying two rights or option positions on the same underlying asset with the same maturity dates, but both have different strike prices. The theory is that the amount received from the short leg of the spread is more than the amount paid for the longer leg, the investor gets an instant credit.
What Does Credit Spread Option Mean?
What is the definition of credit spread option? Because the options used to construct the credit-spread option have the same maturity, investors do not have to worry about how the rates change over the life of the option. The key concern in a credit spread option is to realize a profit by achieving a greater spread on the short leg than in the long leg.
Furthermore, a credit-spread option allows investors to minimize risk and knowing how much money they are risking. On the other hand, credit spreads fluctuate due to inflation changes or changes in the supply and demand for investments.
Let’s look at an example.
Example
Julian buys 10 call contracts on a technology stock for $0.50 at a strike price of $70, and sells 10 call contracts on the same stock for $2 at a strike price of $65. His net credit for the transaction is $1.50 and the credit spread option is executed for a net credit of 10 contracts x 100 shares x $1.50 = $1,500.
If the stock price rises at $80, Julian will exercise his 10 call contracts at a strike price of $70 to acquire 10 contracts x 100 shares = 1,000 shares for a cost of $70,000. At the same time, he is obligated to sell his 10 call contracts at a strike price of $65 for $65,000. Therefore, if the stock price rises above the strike price of $80, Julian will lose $70,000 – $65,000 = $5,000 – $1,500 = $3,500.
If the stock price drops to $63, Julian cannot exercise any leg because they are both out of the money. Therefore, the credit spread option will expire worthlessly, and Julian earns only the net credit of $1,500.
If the stock price rises to $67, Julian cannot exercise the strike price $70 because it is out of the money, but he can exercise the strike price $65 and sell 1,000 shares for $65 = $65,000. To close the position, he will buy 1,000 shares at the stock price of $67 = $67,000, thereby realizing a loss of $67,000 – $65,000 = $2,000 – $1,500 = $500. Depending on the fluctuation of the price, Julian will minimize his losses as long as the market price ranges between $67 and $70.
Summary Definition
Define Credit Spread Option: A credit spread option is an investment strategy that involves purchases and selling put or call options with the same maturity dates and different strike prices on the same underlying securities.
