A credit spread involves simultaneously selling and purchasing an option on the same underlined futures contract but at different strike prices.
The option that you sell is going to be at a higher level or closer to money than the option you purchase, resulting in a net credit for the trade.
Options that are closer to the money have a higher premium associated with them than further away options.
Since you’re selling the option that is closer to the money, you collect more than what you have to pay for the purchased option. This results in a net credit for your account.
Purchasing the option is vital to this trade because it what gives you the defined risk.
Maximum Risk & Reward
The maximum risk can be calculated by taking the difference in the strike prices from the one you sold and the one you purchased. It’s calculated in terms of what it would it be had you had a futures contract.
What you collected for the spread is subtracted and this will give you the maximum risk associated with the trade. Maximum reward associated with the trade is the net collection from when you initiated the trade.
Commission and fees are always added when figuring out both the risk and the reward.
Credit Spread Example
Let’s say, for example, that someone has been doing research on the crude oil market. They have taken a look at the fundamentals and technicals and have decided that the March crude oil market will not go below 95.
Currently, it trades at 100 and this individual is comfortable at initiating a 95/90 credit spread. That means that the person would look at the 95 put. If they sell at $2,095, they would purchase the 90 put.
Currently, it could be purchased for $1,250. In this case, the max reward would be $1,250 minus the commissions and fees.
And the maximum risk associated with the trade would be $3,750 plus commissions and fees.