What is a Credit Spread? (Defined Risk Trading)
A credit spread lets you collect premium like a seller while mathematically capping your maximum loss.
Quick Summary
A Credit Spread is when you sell one option and buy another of the same type at a different strike. You collect a net credit upfront, and the purchased option caps your maximum loss no matter how far the stock moves against you.
Selling options (like Covered Calls or Cash-Secured Puts) puts the odds in your favor. You collect premium while time decay works for you.
But selling options has a dark side: Risk.
The Naked Selling Problem
Unlimited risk can lead to catastrophic losses
NAKED CALL
Sell Call, No Protection
∞ Unlimited Risk
CREDIT SPREAD
Sell + Buy Protection
$ Defined Risk
A Credit Spread allows you to collect income like a seller, but with a strict, mathematical limit on how much you can lose. It's the balance of "being the casino" while wearing a safety belt.
The Definition: What is a Credit Spread?
THE STRATEGY
Sell a High-Premium Option + Buy a Cheaper Option = Net Credit Received
A Credit Spread (also called a Vertical Credit Spread) involves two simultaneous trades:
- Sell a higher-premium option (closer to the money)
- Buy a cheaper option (further out of the money) of the same type and expiration
The goal: Collect more from the option you sold than you pay for the option you bought. The difference is a Net Credit—cash deposited into your account immediately.
Bull Put Spread
Bullish bias—profit if stock stays above short strike
Bear Call Spread
Bearish bias—profit if stock stays below short strike
The "Insurance" Leg
Why buy the second option if it costs you money? Protection.
The cheaper option acts as a catastrophic insurance policy. If the market moves violently against you, that long option kicks in and stops your losses—no matter how far the stock goes. Your loss is mathematically capped at the spread width minus the credit received.
Example: The Bull Put Spread
Current Stock Price
$100
You believe the stock will stay above $90
INCOME LEG
Sell $90 Put
+$2.00 collected
PROTECTION LEG
Buy $85 Put
−$0.50 paid
Net Credit Received
$1.50 ($150 cash)
This is your maximum possible profit
The Possible Outcomes
At expiration: Stock is trading at $92
Both puts are Out of the Money
Both options expire worthless
Result: You keep the full $150 credit. 100% profit.
At expiration: Stock collapses to $50
Your sold $90 Put is losing money (deeply ITM)
But your bought $85 Put is making money too
Below $85, gains and losses offset dollar-for-dollar
Result: Max loss capped at $350, not thousands.
Calculating Max Profit and Max Loss
The Credit Spread Math
MAXIMUM PROFIT
= Net Credit Received
$1.50 × 100 shares
$150
MAXIMUM LOSS
= Spread Width − Credit
($90 − $85) − $1.50 = $3.50
$350
No matter if the stock crashes to $50, $20, or even $0—you can never lose more than $350 on this trade. That's the power of defined risk.
Why Use Credit Spreads?
Three Key Advantages
You don't need the stock to move in your favor. Up, sideways, or even slightly against you can all be profitable.
A naked put on a $100 stock might require $10,000 margin. A $5-wide spread only requires $500 (your max risk).
As a net seller, Theta decay works for you. Every passing day helps your position.
High Probability of Profit (Bull Put Spread)
- Stock goes up? You win.
- Stock goes sideways? You win.
- Stock drops a little (but stays above short strike)? You still win.
- Stock drops a lot (below short strike)? You lose.
Frequently Asked Questions
Summary
A Credit Spread is simply a way to say: "I bet the stock won't go past this line, but I'm buying insurance just in case I'm wrong."
It limits your upside (you can't make more than the credit), but it strictly defines your downside. For sustainable, long-term trading, that's a trade-off many traders are willing to make.
The Credit Spread Trade-Off: Accept a capped profit in exchange for capped risk. Collect premium, let time work for you, and sleep at night knowing exactly how much you can lose.
Important: While credit spreads have defined risk, the maximum loss can still be larger than the maximum profit. A string of losses can quickly erode gains from winning trades. Always size positions appropriately and never risk more than you can afford to lose.
