Definition of Credit Spread
Credit Spread is the difference between the yields of two bonds which has different credit potential but the same maturity date. The strategy is formed by selling the options as and when required and buying another option with the same expiration period. This strategy is very popular among fund managers and some potential investors who are willing to trade on option strategies. It is also said that this strategy can make a consistent return of 10% to 30% in each transaction.
Credit spread strategy makes profits by selling or buying the option time decay. The credit spread can be executed in every 2 to 3 weeks time but it has the potential to make at least 10% to 30% profits every time. The credit spread is classified in two types one is Put Credit Spread and another is Call Credit Spread. The option traders who are willing to invest in put credit spread strategy will always anticipate that the stock price will rise in the future. Similarly, in the case of a call credit spread strategies, the trader will enjoy the profit if the stock market will fall downward. In both these situations, the strategy can make profits because the time decay is always in its favour. Credit spreads are also known as vertical spreads.
Formula for credit spread:
Credit Spread = Corporate Bond Yield – Treasury Bond Yield
The expiration date of both these bonds should be the same to calculate this spread.
How does Credit Spread Work?
The credit spread options are generally used when there are two underlying securities with different credit potential but similar maturity date of expiration. First of all the Put credit spread option is used. In this strategy, the option trader will receive the selling price in the credit of the trading account of the trader and after that, the trader will buy some option at a cheaper price with those funds to make a net profit out of the option strategy. This is how the traders take the benefit of the credit spread.
Example of Credit Spread
An investor is planning to invest in option strategy by using the benefits of credit spread and thus he buys and sells two bonds respectively i.e. Bond A and Bond B. The bond A has a yield of 10% and Bond B has a yield of 5%. Both these bonds are having different credit stands in the market but the maturity date of these bonds is the same and thus the Credit spread is calculated i.e. (10%-5%) equal to 5%.
Credit Spread Chart
In this diagram, the credit spread is explained i.e. for an underlying asset at a certain strike price the investor can achieve maximum loss or maximum profit. The investor will also be aware of the breakeven point in this transaction and therefore they can make their decisions accordingly. Credit spread can help the investors predict in advance about the possibilities of the profit in this option strategy. This strategy is also known as the vertical spread strategy.
Credit Spread Analysis
Credit Spread is an option strategy used by investors who are willing to invest in the options. The investors can gain up to 30% in each transaction. The credit spread can be understood by investing in underlying assets with the same expiration period but different credit capacity. The investor will gain from the spread of the returns from these bonds while the investors will buy or sell the underlying assets.
Credit Spread Risk
The credit spread risk is associated with the difference in returns of the underlying asset at the time of expiration. The market is fluctuating every moment the price of any stock can go downward or can get upward and in this scenario the investors who are anticipating an arbitrage profit may not enjoy this position. Hence the risk is the market condition in this strategy. Credit spread can be very risky if the size of the security is big. Credit spreads are less risky than any stock trading in the market.
Why is Credit Spread Important?
Credit spread is important because it gives the investors an idea about the expected gain from the options swaps. The investors can get an indication about the bond’s yield by understanding the spreads of the underlying assets. The credit spread can give you an idea about how much a market can move by anticipating the spreads. Credit spreads are also a key factor to analyse the bond price in an economy. The credit spreads can help the investor to anticipate the prices and thus the investors prepare themselves for Call or Put credit spread. The credit spread involves buying and selling of option contracts that belongs to the same class but have different credit capabilities. Therefore it becomes important for the investors to analyze the market condition and also the key indicator which is the credit spread.
The Credit spread is an indicator for the traders who are willing to invest their proceeds in this option strategy. The credit spread can, however, help the investor to opt for the right option i.e. Call credit spread or Put credit spread. The credit spread involves buying and selling of options as per the situation demands. This strategy is such that the investors can make out about much profit they can make in each transaction. The credit spread strategy also helps to manipulate the risk factors if any prevailing in the market. The price fluctuation in the market or any other market movement will not drastically affect this strategy. However, the investors who are willing to invest in this strategy should have deep knowledge about these strategies. These strategies are very helpful for those who clearly understand the concept. Credit spread is subjective because it varies from security to security. The expiration date of the underlying assets should be the same. This option strategy also helps to overcome the uncertainty which is always prevailing in the market.
This is a guide to Credit Spread. Here we also discuss the definition and how does credit spread work? along with an example and importance. You may also have a look at the following articles to learn more –