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A credit spread is an Options Strategy formed by selling one option closer to the money and then buying another further away for a lower price.

The difference between credit and debit Spreads is that credit Spreads result in a net credit being paid due to Short side being closer to the money and therefore more valuable.

The maximum risk of a credit spread is limited to the distance between the Short and Long positions multiplied by the number of contracts. The maximum gain is also limited to the Premium from the sale of the Short option minus the cost of the Long option - i.e. the spread between the two Options. If the option expires above the Strike Price of the Short Put or below the Strike Price of the Short Call, then the Option Writer keeps the Premium from the Short side. Their protective Long option is worthless also, however, so the lower cost of that must be deducted from the net profit.

A put credit spread is sometimes called a Bull Put Spread because the strategy benefits when the price of the Underlying asset or commodity increases. A call credit spread is also called a Bear Call Spread, since this strategy becomes profitable when the price falls.

Although a credit spread can have a Bullish or Bearish bias, they are classed as partially non-directional Options strategies because even if the price moves towards the strikes prices of a credit spread, providing the Short side does not expire In The Money then the credit spread Option Writer still keeps the Premium and the trade remains profitable.

Credit Spreads are frequently used as building-block Options strategies with other more complex types of Options trades, most notable of which is the Iron Condor which is composed of a Bull put and Bear call credit spread below and above the current market price of the Underlying asset or commodity.

Credit Spreads have some similarities with high yield fixed income investments since the profit obtained from them is usually considerably lower than the maximum potential loss but they have a lower and more defined risk than Long Options or naked Short positions which can result in a total loss of the capital invested (for Long positions) or a theoretically unlimited liability (for Short positions).
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Contributed by: Ralph Windsor

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Credit Spreads

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