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Credit Spreads: Defined-Risk Premium Selling

For educational purposes only; not investment advice.

Direct answer

Section titled “Direct answer”

A credit spread sells one option and buys a farther-out option of the same type, underlying, expiration, and contract quantity. The short option is more valuable, so entry produces a net credit. The long option limits the short option’s expiration loss while also reducing the premium retained.

The two basic forms are a bull put spread—sell a higher-strike put and buy a lower-strike put—and a bear call spread—sell a lower-strike call and buy a higher-strike call. Both have limited maximum gain and loss at expiration. “Defined risk” remains reliable only while the matched spread stays intact and deliverables are compatible.

Structure and payoff

Section titled “Structure and payoff”

Let strike width be W, net credit be C, and multiplier be M, commonly 100 for standard U.S. equity options:

  • Maximum gain = C × M
  • Maximum loss = (W−C) × M
  • Bull put break-even = short put strike − C
  • Bear call break-even = short call strike + C

A bull put spread reaches maximum gain when the underlying finishes at or above the short put strike and maximum loss at or below the long put strike. A bear call spread reaches maximum gain at or below the short call strike and maximum loss at or above the long call strike.

The net position is often positive Theta and negative Vega near entry, but these are not constants. Moneyness, time, skew, and different Greeks on the two legs can change the net exposure. Before expiration, a spread can show a loss larger or smaller than a simple payoff-line estimate without exceeding its theoretical expiration loss if both legs remain valid and executable.

A 5-point spread opened for 1.20

Section titled “A 5-point spread opened for 1.20”

Assume a spread is 5 points wide and produces a 1.20 credit. With a 100 multiplier, maximum gain is 1.20×100=$120, while maximum loss is (5−1.20)×100=$380, before fees.

Bull put example: sell the 100 Put and buy the 95 Put.

  • At 100 or above, both expire worthless and profit is $120.
  • Break-even is 100−1.20=98.80.
  • At 97, the short put’s $300 intrinsic loss minus $120 credit leaves a $180 loss.
  • At 95 or below, the long put offsets further decline and loss is capped at $380.

Bear call example: sell the 100 Call and buy the 105 Call for the same credit.

  • At 100 or below, both expire worthless and profit is $120.
  • Break-even is 100+1.20=101.20.
  • At 103, intrinsic loss is $300; after the credit, loss is $180.
  • At 105 or above, loss is capped at $380.

The initial $120 is cash flow, not earned profit. Closing the spread costs its current debit; realized P/L is the opening credit minus that closing debit and transaction costs.

Risk and execution checklist

Section titled “Risk and execution checklist”
  • Enter and exit with a supported multi-leg limit order; separate fills can create temporary naked-option exposure and slippage.
  • Size the trade from the $380 maximum loss, not the $120 credit.
  • Keep the protective long leg until the short leg is closed or otherwise neutralized. Selling it first can remove the loss cap.
  • A short American-style option can be assigned early. The broker does not necessarily exercise the long leg automatically, so assignment can create a temporary stock position and financing need.
  • Near expiration, a price between the strikes can leave the short leg exercised and the long leg expired. After-hours moves and holder instructions add uncertainty.
  • Do not assume quoted midpoints are executable. Review the combined bid-ask spread, depth, fees, and open interest for each leg.
  • Check adjusted deliverables, settlement style, and exercise style; a standard equity spread and a cash-settled European-style index spread can behave differently.
  • Theta is not guaranteed income. A sharp directional move, volatility increase, or near-expiration Gamma can overwhelm time decay.

Common misconceptions

Section titled “Common misconceptions”
  • “Receiving a credit means the trade is already profitable.” The credit is paired with an open obligation and is earned only through the eventual exit or settlement.
  • “Probability of profit equals expected return.” Frequent small wins can still be offset by less frequent losses near $380.
  • “The long leg prevents assignment.” It limits economic loss at expiration; it does not stop a holder from exercising the short option early.
  • “Any two short-and-long options form one credit spread.” The standard vertical uses the same type, expiration, underlying, quantity, and compatible deliverable.
  • “Maximum loss can never be exceeded.” The formula excludes commissions, taxes, poor execution, temporary stock exposure, mismatched legs, and operational mistakes.
  • “All credit spreads are bullish.” Bull put spreads are neutral-to-bullish; bear call spreads are neutral-to-bearish.
Section titled “Related topics”

Authoritative sources

Section titled “Authoritative sources”