Credit Spread Option
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<< Vertical Spread Option Spread >>At the heart and soul of the iron condor trade is the credit spread option strategy.
Credit spreads are a way for option sellers to sell premium without the risk of doing so naked - or uncovered. Because the credit spread is comprised of 2 options - the sold option and the purchased option to ‘cover’ the short position - option sellers are able to generate good premiums with limited risk.
A credit spread option example could appear as is following…
Sell 4 AAPL 200 Puts
Buy 4 AAPL 195 Puts
If an option trader were to sell a similar ‘naked’ position as the one above, the risk would be huge as the trader would be liable to purchase the stock at 200 even in the event that the stock crashed to 0 overnight. Although some might argue that this would never happen - gigantic gaps can and have happened - and many a naked cal and put seller have been burned. In fact similar situations have been known to out traders completely out of business.
Back to our example, if a trader were to put on a similar position - only doing it without the purchased 195 put for ‘coverage’ - in the event of a dramatic down move the trader would be liable for purchasing the stock at 200 per share regardless of where the stock wound up free falling to.
However, with the 195 put purchased for ‘coverage’ - the most the trader can lose in a sell off situation is the difference between the two strikes of the spread (5.00) minus the credit that was originally brought in.
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