A vertical credit spread is when you both sell and purchase an option of the same stock. It is a credit because you sell an option with a higher premium than the option you purchase. The result is a net credit. The vertical refers to the fact that the expiration is the same for both options. This trade can be a bit riskier and more complicated than covered call and cash secured put strategies. This is primarily due to having to do two trades and you must have enough cash or margin to cover the trade if it closes in the money. Initially, this can be confusing to new option traders. So, let us discuss one of my trades.
In my October Review I did my first vertical credit spread on October 12th on Microsoft. Here is the trade. (MSFT Vertical Call Spread 11/20 245/255). On October 12th I sold a call on MSFT expiring on 11/20 at a strike price of $245. At the same time, I purchased a MSFT Call at $255 on the same expiration day. I received $2.27 for the sale of the $245 contract. I paid $1.08 for the $255 contract. The net credit for the spread was $119 (2.27-1.08) *100 shares before any trading costs. You might be wondering why I would do such a trade if it is more complicated and potentially riskier. One of the big benefits of a spread like this is that it requires less cash or margin on the transaction. For this trade I must have $881 in my account. For the same covered call, I would need 100 shares of MSFT or enough cash to purchase 100 shares. One thing to remember is that it is still important to use the same rules for spreads. In this transaction I was looking for an increase of 10% and a Delta of at least .20. The delta for the 245 call was .187 and on October 12th the price was around $220.
You can also do credit spreads on puts. They work the same way but the further out of the money you are the lower the stock price. So if the above trade was for a put you would sell a put at 255 and buy a put at $245. The margin would the same and if assigned you would be buying the stock vs selling. Below is a good video that does a better job explaining it. As always let me know if you have any questions or comments.
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