Options Forum: Risk in Credit Spreads

I'm an avid reader of your excellent and commonsense columns. Would you consider a column commenting on: 1. Credit spreads; 2. the risks involved; 3. and the appropriateness of engaging in them for novice option investors such as myself. I'm really concerned about risk: What if I get assigned? Or, is the assumption being made that I will (can?) close out the credit spread before being assigned? What happens if I cannot close out both sides of the trade? Thanks in advance. -- R.C.

The first takeaway from this reader's email should be that flattery always helps. I was about to refer this reader to a recent column on credit spreads when I received a quick follow-up email saying he had already read the recent article but still had some questions regarding the mechanics and risk involved.

The real risk to credit spreads is always simply the difference between strike prices, minus the credit received. So, if you sell a $35/$40 call spread for a net credit of $2, the position's maximum profit is limited to $2, while the maximum loss is $3 per spread. One of the problems with credit spreads, compared to debit spreads or simply buying premium, is that even though they have a higher probability of being profitable (by profitable I mean earning even a single penny), the absolute risk/reward of the position is usually less than the even money.

You can always close out a position prior to expiration. But be aware that the maximum profit of a vertical credit spread usually cannot be realized until expiration. In fact, one of the drawbacks of most spreads, debit or credit, is that the maximum profit cannot be realized until expiration or until the position moves very deep in or out of the money.

You should always open and close spread positions as a spread, a single transaction, not making an attempt to leg into them. This means you will be closing both sides. Most online brokers now offer the ability to enter multi-strike transactions as a single order. With electronic trading and exchange linkage, the bid/ask on spread orders usually will be much tighter than entering the legs as separate pieces.

And given that brokers still do get paid a little something for executing trades, spread orders, which used to lay in mothballs on the "spread book," now are very likely to get filled not only in a timely fashion but at a price that represents fair value between the bid and the ask.