Credit Spreads

Credit Spreads
Your Guide to Successful Options Trading
One of the main methods for classifying options spreads
is based on the capital outlay involved. In this respect,
there are basically two types; credit spreads and debit
spreads. Credit spreads are named appropriately because you actually
receive credit at the initial point of transacting, usually
in the form of cash into your trading account. They can play
an important part in your trading strategy, depending of
course on what strategies you are actually using.
On this page we provide further detail on them, covering
the following topics:
These are created by placing two separate orders on
options contracts related to the same underlying security.
First, you would use a sell to open order to take a short
position on a contract by writing it. By writing and selling
a contract, or contracts, you receive the sale price as a
credit to your trading account.
You would then use some of those funds to buy cheaper
contracts on the same underlying security using a buy to
open order. Assuming your investment in the options you buy
is less than the money you receive for those that you sell
then you have a positive net position at that point, thus
creating a credit spread.
A common way to create a credit spread is to write
options contracts that are either in the money or at the
money, and then buy cheaper contracts on the same security
that are out of the money. For example if you wrote 100 in
the money contracts that were trading at $1.50 and bought
100 at the money contracts, on the same security, that were
trading at $1.00, then you would receive $150 for writing
the contracts and reinvest only $100 into buying contracts.
This would give you a cash positive position of $50.
A credit spread basically consists of combining a short
position on options which are in the money or at the money
together with a long position on options that are out of the
money. By using some of the funds received from taking the
short position on adopting the opposing long position, you
are limiting the risk you are exposed to.
Taking the short position would obviously come with a
margin requirement, and by creating a credit spread you can
reduce that requirement; due to the fact that the risk
element is at least partially offset by the long position.
If you are not familiar with how margin is used in options
trading then please visit our page which explains the subject in
detail here.
For example, if you wrote calls on a particular stock
then you would be exposed to the risk of that stock going up
in value, above the strike price. You would be obliged to
sell the holder of those contracts the underlying stock at
the strike price if they chose to exercise.
If you had written those contracts without owning the
underlying stock, known as a naked write, then you would
have to buy the stock at the higher trading price before
selling them to the holder at a loss. However, if you also
owned calls contracts on that stock, then you would be able
to exercise and buy the stock at the strike price contained
in those contracts.
Therefore, in very simple terms, the risk you are exposed
to is limited to the difference between the strike price in
the options you have written and the strike price in the
ones you have bought. In the above example, your loss on the
ones you have written increases the higher the underlying
stock rises. However, your gain on the ones you have bought
also increases at the same rate. This is much less risky
than a simple naked write position, where your losses are
theoretically unlimited.
As you can see, credit spreads are a useful tool for
limiting risk while still being able to profit. By writing
calls and buying calls to create a credit spread, you will
usually make a profit if the underlying security falls in
price or stays fairly stable. Depending on the exact
features of the options involved, you may even make a profit
if the price of the security goes up by just a small amount.
As outlined above, your risks are limited if the security
does rise in price so there are clear advantages of using
credit spreads. As well as the risks being limited,
so are the profits. The maximum profit you can make is
basically the money you receive for writing the options you
sell minus the cost of the ones you buy.
Because it's possible to make profits spreads regardless
of what direct the price of an underlying security moves in,
these spreads can be used in a number of trading strategies,
including multi-directional strategies. As a general rule,
they are used when small moves in the price of the
underlying security are expected.
There are a number of different types of credit spreads
that you can use in options trading, depending on what your
strategies are and what market movements you are expecting.
In our section on
Options
Trading Strategies you will find more details of how
they are used. The following are the commonly used.
There are four main advantages of credit spreads.
First, when you create them you will receive cash up front
into your trading account. The fact that you can limit your
losses is obviously beneficial, as is the fact that you can
use them to gain a profit based on the underlying security
moving in more than one direction. They have the advantage of
requiring a lower margin requirement than naked writes.
One disadvantage is that they do still require
you to trade on margin, which is not something you need to
do if you are just straight up buying options contracts.
Also, although you are limiting your potential losses, you
are limiting your profits too; this means the risk to reward
ratio is not usually that favorable.
Copyright &© 2017 OptionsTrading.org - All Right Reserved.

Read Review
Visit Broker

Read Review
Visit Broker

Read Review
Visit Broker

Read Review
Visit Broker

Read Review
Visit Broker

Will Kenton is an expert on the economy and investing laws and regulations. He previously held senior editorial roles at Investopedia and Kapitall Wire and holds a MA in Economics from The New School for Social Research and Doctor of Philosophy in English literature from NYU.

Learn about our
editorial policies

Charles is a nationally recognized capital markets specialist and educator with over 30 years of experience developing in-depth training programs for burgeoning financial professionals. Charles has taught at a number of institutions including Goldman Sachs, Morgan Stanley, Societe Generale, and many more.

Learn about our
Financial Review Board

Learn about our
editorial policies

A credit spread option is a type of strategy involving the purchase of one option and the sale of a second option. The two options in the credit spread strategy have the same class and expiration but vary in terms of the strike price. As an investor enters the position, he receives a net credit; if the spread narrows, he will profit from the strategy.

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset.

A credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. It also refers to an options strategy.

A debit spread is a strategy of simultaneously buying and selling options of the same class, different prices, and resulting in a net outflow of cash.

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a particular period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased.

Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a stated price within a specified period.

Cash-settled options pay out in cash upon expiration or exercise, rather than delivering the underlying asset or security.

Credit Spread vs. Debit Spread: What's the Difference?

Tips for Answering Series 7 Options Questions

What Does Positive Theta Mean for Credit Spreads?

The Basics of Options Profitability

#

A

B

C

D

E

F

G

H

I

J

K

L

M

N

O

P

Q

R

S

T

U

V

W

X

Y

Z

Investopedia is part of the Dotdash Meredith publishing family.

We've updated our Privacy Policy, which will go in to effect on September 1, 2022. Review our Privacy Policy

Daniel Rathburn is an editor at Investopedia who works on tax, accounting, regulatory, and cryptocurrency content.

In the financial world, a credit spread option (also known as a "credit spread") is an options contract that includes the purchase of one option and the sale of a second similar option with a different strike price. Effectively, by exchanging two options of the same class and expiration, this strategy transfers credit risk from one party to another. In this scenario, there is a risk that the particular credit will increase, causing the spread to widen, which then reduces the price of the credit. Spreads and prices move in opposite directions. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level.

The buyer of a credit spread option can receive cash flows if the credit spread between two specific benchmarks widens or narrows, depending upon the way the option is written. Credit spread options come in the form of both calls and puts, allowing both long and short credit positions.

Credit spread options can be issued by holders of a specific company's debt to hedge against the risk of a negative credit event. The buyer of the credit spread option (call) assumes all or a portion of the risk of default and will pay the option seller if the spread between the company's debt and a benchmark level (such as LIBOR) grows.

Options and other derivatives based on credit spreads are vital tools for managing the risks associated with lower-rated bonds and debt.

Individual Bonds vs. Bond Funds

Corporate Bonds vs. Stocks

Corporate Bonds vs. Muni Bonds

BondSavvy vs. Financial Advisors

Brochure

Our Investing Strategy

Our Founder

Blog

Corporate Bond FAQ

How To Invest in Corporate Bonds

Crash Course Video ($)

BondSavvy Subscriber Benefit BondSavvy compares credit spreads and YTMs to a bond issuer's leverage ratio and other financial metrics to identify corporate bonds that can increase in price and achieve strong total returns. See Our Performance

BondSavvy Subscriber Benefit We seek to maximize the total return of each corporate bond recommendation. Our disciplined approach on deciding when to sell bonds enables us
to achieve this goal. Get Started

BondSavvy Subscriber Benefit BondSavvy recommends both investment-grade and high-yield corporate bonds, which empowers subscribers to succeed in a variety of investing environments.
Get Started

Get Started

Sample
Sample Edition of The
Bondcast

About
Brochure
Our Founder

Learn
Blog
Corporate Bond FAQ
How To Invest in Corporate Bonds
Crash Course Video ($)

Contact us
Contact Form
(201) 748-9862

Credit spreads, also known as Treasury spreads, are the difference between a corporate bond's yield to maturity ("YTM") and the YTM of a US Treasury bond
or note with a similar maturity date (the 'benchmark Treasury'). The credit spread represents the extra compensation, or yield, a corporate bondholder
receives above the so-called risk-free rate of the US Treasury bond. (We don't believe a government that runs trillions in red ink is "risk free,"
but that's a discussion for a different day.) Since corporate bonds are deemed to have a higher default risk than the US government, corporate
bond YTMs are higher than Treasury bond YTMs for bonds of similar maturities. The amount of this difference is the credit spread.

As we discuss in this post, movements in Treasury bond yields and credit spreads will impact corporate bonds in different ways. Treasury yields
and credit spreads are the building blocks to a corporate bond's YTM and understanding how their movements impact corporate bond prices is essential
knowledge for all corporate bond investors.

The best way to show how credit spreads work is through an example of a corporate bond BondSavvy previously recommended and has subsequently sold after
the bond price increased 25 points. The recommendation was for Tiffany bonds 4.900%
'44 (CUSIP 886546AD2). We recommended the Tiffany '44 bonds on September 5, 2019 at an offer price of 103.01 and a YTM of 4.70%.

In Figure 1, we show the Tiffany bonds' YTM has two components: 1) the benchmark Treasury YTM, shown in blue and 2) the credit spread, shown in orange.
The 'benchmark Treasury YTM' is the YTM of a Treasury bond that has a similar maturity date to the Tiffany bonds' maturity date. Since the maturity
date of the Tiffany bonds is October 1, 2044, the benchmark Treasury is the US Treasury 3.00% 11/15/44 bond (CUSIP 912810RJ9). The reason the benchmark
Treasury has a similar maturity date to the corporate bond we are evaluating is that we want to isolate what part of the corporate bond's yield is moving
due to movements in US Treasury yields vs.
the portion of the yield that is changing based on the credit-risk component of the bond. If we selected a Treasury bond with a maturity date in
2025 instead of 2044, there would be differences in the benchmark bonds' maturity dates, which would impact the YTMs of both bonds. By referencing
the corporate bond against a Treasury bond with a similar maturity, we can identify the portion of the YTM that is the credit spread.

On September 5, 2019, the US Treasury '44 bond had a YTM of 1.99%. Since the Tiffany bonds had a YTM of 4.70%, the credit spread was 2.71% or, 271
basis points. For bond newbies, 100 basis points (often shown as 'bps' and pronounced as 'bips' or 'beeps') equals 1 full percentage point.
Fifty bps equals 0.50%.

Figure 1: YTM Building Blocks: Tiffany 4.900% 10/1/44 Bond
Prices and yields sourced from Fidelity.com
Since the credit spread on the Tiffany bonds was 2.71% on September 5, 2019, if we were to hold the Tiffany bonds until the maturity date, we would receive
2.71 percentage points of additional annual return compared to the US Treasury '44 bond. We receive this extra yield since the Tiffany bonds are deemed
to have a higher risk of default than the US Treasury bonds. Bonds with a low -- or narrow -- credit spread are generally deemed to have a higher credit
quality and less default risk than bonds with a higher -- or wider -- credit spread.

In Figure 1, the YTM of the Tiffany bonds was 4.70% on September 5, 2019. This corporate bond YTM will move up and down based on movements in the credit
spread and the benchmark Treasury yield. Assuming no change in the US benchmark Treasury YTM, if the credit spread increases, the Tiffany bonds' YTM will
increase, which will cause the bond price to fall. Should the credit spread shrink, the bond's YTM will also shrink causing the bond price to increase.
The same dynamic happens if the credit spread goes unchanged and the benchmark Treasury yield increases or decreases.

The reason why the Tiffany bonds increased in price from 103.10 to 128.00 over the course of 4 1/2 months is there was a sharp decline in the Tiffany bonds'
credit spread. This credit spread decline was driven, in large part, by LVMH and Tiffany entering into an agreement on November 25, 2019 where LVMH was
going to acquire Tiffany. Many investors believed the combined LVMH-Tiffany would be of a higher credit quality than Tiffany standalone and, on November
26, 2019, S&P put Tiffany's bond ratings on 'CreditWatch Positive,'
since Tiffany (rated BBB+ by S&P) was being acquired by a higher-rated entity in LVMH, which was rated A+. LVMH would assume the Tiffany debt
as part of the transaction and, generally speaking, when a higher-credit-quality company acquires a lower-credit-quality company, the bonds of the lower-rated
company should move up in ratings to match the acquiring company's bond ratings, provided the acquisition doesn't materially worsen the acquiring company's
credit profile.

As the Tiffany bonds' credit spread fell from 2.71% to 0.96%, the bonds' YTM fell to 3.20% and the bond price increased to 128.00. At the time, this
credit spread was in spitting distance of certain Apple bonds. Since Apple has a far superior credit quality than Tiffany (Apple's $200+ billion in cash
has a big impact on that), we didn't believe the Tiffany bonds' credit spread could fall much further and, as a result, we decided to sell the Tiffany
bonds at 128.00 and achieve a 26% total return. Please read the full blog post of our Tiffany bonds investment and view our investment returns from
our current and previous corporate bond recommendations.

While the Tiffany bonds' credit spread shrunk significantly, the benchmark Treasury bond YTM increased 0.25 percentage points. This was a moot point,
however, since the credit spread decreased by such a larger amount than the Treasury bond YTM increased, which is why the bond price increased 25 points.

Many investors might be surprised that a corporate bond's price could increase 25 points over the course of four and one-half months. The reason
this could hap
Teasing And Masturbating
Sperm Selfie
Xvideos Triple Penetration

Credit Spreads

Report Page