Your Safety is level in Check (Credit Spread)

A vertical credit spread is constructed by buying one option and selling another option of the same type (call or put) in the same expiration month, where the option sold is more expensive than the option bought, resulting in a net credit to your trading account.

In contrast to a debit spread, where you simply pay the difference, with a credit spread there is a margin requirement based on the difference in the strike prices. Note that when you place a credit spread, your price expectation is completely opposite that for a debit spread. In the call debit spread, you want the underlying to go up. This would widen the spread, allowing you to sell it later for a profit. In the call credit spread, you want the underlying to go down. This would narrow the spread, allowing you to close it later for a profit.

If this seems a difficult concept to grasp, perhaps this will help: You can think of opening a debit spread as going long the spread and opening a credit spread as going short the spread. Just as when you go long a stock, when you go long a spread you hope its value increases. And just as when you short a stock, when you short a spread you hope its value decreases (so that you can buy it back later at a lower price). Debit and credit spreads can be formed using puts as well, with their performance curves mirror-imaging those of call debit and credit spreads.

Practically, there is little difference between the way debit spreads and credit spreads perform. Both have upper and lower boundaries to their potential values. Their value can go to a minimum of zero or to a maximum of the difference in strike prices. Neither is there much difference in what they cost, nor any practical difference in how you trade them. So when would one want to use a credit spread instead of a debit spread?

There is one distinction, and it is a subtle one. Depending on the strikes chosen, the credit spread is more often used when you have a conviction of what the underlying will not do (i.e., will not penetrate a support or resistance level). In contrast, the debit spread is used more often when you have a conviction of what the underlying will do (i.e., will continue its trend).

When there is a support level you feel the underlying will not penetrate, you would typically select a put credit spread where the short option is at or just below the support level. Likewise, when there is a resistance level you feel the underlying will not penetrate, you might typically select a call credit spread where the short option is at or just above the resistance level.

Sometimes the use of credit spreads is motivated more by the desire to sell options while avoiding naked writing. When a trader wants to sell out-of-the-money options to collect time premium (perhaps selling both out-of- the-money calls and out-of-the-money puts), he often buys farther out- of -the-money options at the same time in order to cover his short options and avoid using naked writing (either because of the open-ended risk of naked writing or because of its high margin requirements). This creates credit spreads. Just as if he used naked options, the investor is expecting that the underlying will not go as far as the strike price of the short options.

If he is successful, the short options, as well as the farther out-of-the-money

long options, will expire worthless. Naturally, his proceeds are less for having bought the farther out-of-the-money options for protection

Spreads                                                  View

Call debit                                                  Bullish

Call credit                                                 Bearish

Put debit                                                   Bearish

Put credit                                                  Bullish

Happy Trading!!!

Cheers.