Credit Spreads, in options trading, represent a defined-risk strategy where an investor simultaneously sells an option with a higher premium and buys an option with a lower premium, both on the same underlying asset, with the same expiration date, and of the same option type (calls or puts). The fundamental purpose is to generate income from the net premium received, anticipating that the underlying asset’s price will remain within a specific range or move favorably relative to the strategy’s construction.
Mechanism
This strategy involves two legs: selling an out-of-the-money (OOTM) option and buying a further OOTM option to cap the potential loss. For instance, a bull put spread involves selling a higher-strike put and buying a lower-strike put, yielding a net credit. The maximum profit is the initial net premium collected, while the maximum loss is limited to the difference between the strike prices minus the net premium received, clearly defining the risk-reward profile.
Methodology
The methodology of employing credit spreads is rooted in a disciplined, income-generating approach, often utilized when a trader expects limited directional movement or a slight bias in the underlying asset. It systematically capitalizes on time decay (theta) and limited volatility. This strategy serves as a foundational component for institutional options traders aiming for consistent returns by monetizing options premiums while judiciously managing downside risk, a critical consideration in the dynamic and evolving crypto options landscape.
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