Credit Spreads are a combination of 4 options, both puts and calls. This type of spread is said to be delta neutral. You profit if the market stays in a trading range. Credit Spreads are a limited risk and limited reward spread.

The spread is always done for an initial credit. If you don't receive a credit when you place the trade then you didn't do a credit spread. We will review spread establishment from the call and put side.

Call Side
Sept '04 futures are trading at 1075.00
Look at options 20 points higher than the current market price.

Example
Sept '04 1095.00 call	11.10	$2,775.00
Sept '04 1100.00 call	9.20	$2,300.00

Always sell the call closest to the current market price. Doing so creates the credit. Buy the further out call for protection (defined later).

Sell Short Sept '04 1095 call	11.10 points	$2,775.00
Buy Sept '04 1100 call	9.20 points	$2,300.00
Net Credit:	1.9 points	$475.00
Any credit received must be reduced by commissions and any other trade fees. For example if your commissions and trade costs were $35 per option then the credit would be adjusted by $70 ($35 per option) for a total credit of $405.00

Put Side
Sept '04 futures are trading at 1075.00
Look at options 20 points down from the current market price.

Example
Sept '04 1055.00 puts	11.80	$2,950.00
Sept '04 1050.00 put	10.50	$2,625.00

Always sell the put closest to the current market price. Doing so creates the credit. Buy the further out put for protection.

Sell Short Sept '04 1055 put	11.80 points	$2,950.00
Buy Sept '04 1050 put	10.50 points	$2,625.00
Net Credit:	1.3 points	$325.00
Any credit received must be reduced by commissions and any other trade fees. For example if your commissions and trade costs were $35 per option then the credit would be adjusted by $70 ($35 per option) for a total credit of $255.00

Total Credit
The total credit on the spread is the call premium plus the put premium.

Total Credit =	(call premium + put premium) - trade fees
Total Credit =	(1.90 + 1.30)
Total Credit =	3.20 points or $800
Total Fees =	$140
(Commissions and trade fees were assumed at $35 per option [4 options used].)
Total Net Credit =	$660

Spread Risk
The risk of a credit spread is the greatest difference between either the call side or the put side. In our example there is a 5-point spread on the calls and a 5-point spread on the puts. The maximum risk is 5 points for the entire spread. Why not a risk of 10 points? The market can expire only through one side of the spread. It is impossible for the S&P to expire above 1100 and below 1050.

The net risk of the spread is the 'Spread Risk' (see above) minus the total credit received plus any trade fees. The Sept '04 example shows a total credit of 3.20 points (call credit + put credit).

Net Risk =	(Spread risk - total credit) + trade fees
Net Risk =	(5.00 points - 3.20 points) + $140
Net Risk =	(1.80 points) + $140
Net Risk =	$450 + $140
Net Risk =	$590

Protection
You may be wondering why buy the further out call and put. Recall that Credit spreads are a limited risk type of spread. You know the total risk of the trade before entering the market. If you don't buy the further out call and put you place the account into an unlimited risk scenario. Let say you don't buy the put at 1050. You are responsible dollar for dollar for each point move below the put you sold. If some economic report is released, some act of terrorism, a Federal Reserve announcement or any other negative news the market could drop substantially.  You could quickly lose a substantial amount of money. 

Another benefit of the protective call is the savings in margin. In the futures markets the margin requirement of a credit spread is typically the total risk of the trade. A trade without the further out options creates a much higher margin level. In some cases margin could be 20 - 30 times the margin requirement of a credit spread.

Option selection
Remember to give the market some room to move when choosing options. Look at the typical daily trading range of a market. Be 3-5 days outside of the range at a minimum. If you use a 40 point spread up, then use a 40 point spread down.

Risk of Exercise
In the case of Credit spreads it is possible for the market to be below the price of the short put but above the long option at exercise. S&P options are cash settled, meaning that instead of receiving a futures contract at your strike price, your account is debited or credited with the dollar amount of any option trades. In our S&P example, assume that at expiration the S&P futures are trading at 1053. The short put option at 1055 would be against the position by 2 points (short put options in this situation are similar to a long futures). Your account would be debited by 2.00 S&P points plus any transaction fees associated with the trade.

Assume that at expiration day the S&P futures are trading at 1045. The short put option at 1055 would be cash settled and a debit of 10 S&P points would take place. The long put option at 1050 would be cash settled and a credit of 5 S&P points would take place. The two cash transactions would offset into a net debit of 5 S&P points plus any trade fees associated with this trade.

We recommend taking profits and closing positions on open spreads if you have realized 75% of the total option premium collected. Also, if the market trades within one day's range of your spread you may elect to roll the position up or down depending on which side need's to be defended.

Profiting
The position profits if the market stays within the options you sold. Our S&P example has an upper band of 1095 and a lower band of 1055. If the market stays within that trading range then both sides expire worthless and you collect all of the premium.

Option Values Before Expiration
At expiration options are worth 100% of intrinsic value. Prior to expiration options can be worth more or less than their intrinsic value. Various market forces act on option prices prior to option expiration. Some of these forces are time before expiration, market volatility and interest rates. For example an important government report could cause a market to drop tremendously. Put option values for this market could jump considerably in response to the news announcement.

Uses for Credit Spreads
Credit spreads are effective in larger markets. The S&P 500 futures, Bonds and Ten Year Note futures, some currencies and even Crude Oil are typical markets for Credit Spreads. Smaller markets typically do not have significant enough option premiums for credit spreads.

Time decay is the reason Credit Spreads work. Options depreciate a little each day before expiration. Time decay increases substantially during the last 30 days of an option's life. Maximize your time in the market by looking for options with 30 days before expiration.