An option trader might suggest to you that Bookworm has over simplified the term "credit spreads".
Any option spread on a single underlying asset, where the trader takes in more money than he pays out to make it a credit maybe a more simplified way to express it. My definition.
I have traded many credit spreads that were diagonals.
I thought I would do some research to help here, but most experts do not truly understand what it is. Credit Spread, Credit Spreads, Credit Spread Option Trading, Trading Options Spread
"A credit spread in a simple option trade in which the trader sells one option and buys another option farther away from the money. This results in a credit to the trader. This credit is the [B]max amount[/B] that can be made on the trade and is deposited into the traders account as soon as the trade is made."
Note first that he covered a key component to the long option: an option farther away from the money.
But with Diagonal Credit spreads, the maximum potential gain on the position cannot be determined until the short option expires. I have had one where I only collected $7 per contract and the total gain was over $40 after the short option expired and the following Monday I closed the long option.
The more you study and research options, the more interesting strategies you will see available at your fingertips.
Its not rocket science, but it does take getting very familiar with options.
You might like to know that most of these seldom go against the trader. Something to consider with part of your investing capital.
Broaden your horizon.
PS The URL I posted sure didn't look as it does now.
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NOTE: This "Note first that he covered a key component to the long option: an option farther away from the money." is not necessarily accurate. So, even the expected most accurate statement can be found with an error. Consider that you were long a call option at the money-ATM and short a call option in the money-ITM. In that case, the short option is actually further from the money than the long option. So, I will stick with my definition, as the more info one tries to use to describe a credit spread, the more parts of the description can be picked apart.
And, yes, I have used such a credit spread (both vertical and diagonal) and they worked very well.
One reason, and the reason I used on an occasion, was the other options on the stock, be it call or put, were not being traded and the only way to get off the trade was to use a credit spread. Some would say just sell naked options, but I have never fallen into that group. "Great" consistent winning traders have gone broke using that method and one big loss can wipe out all your former winners.
Maybe this is more than you wanted to know about credit spreads, but being educated can prevent hard knocks. I have had enough early on in my trading. Learn and avoid.
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If you selling the credit spread, you can close it by buying it back, but there will be commission, if you wait until expiration then you can save on the commission.
Yes, if the underlying stock don't move enough toward your direction, time decay have not work on your favour too early, and you may need to buy back at higher cost due to the greeks differences and spread.
30 to 45 days till expiration will be the optimum to allow theta decay work toward your favour, but may need adjustment if stocks goes against your direction.
1. You sell a credit spread and collect a premium. In order to close it, you can buy the spread back at whatever price it is trading at.
2. So a spread has 2 legs - a short leg and a long leg. The long leg serves as a protection (insurance). ideally when you are selling a credit spread or buying it back, you dont really have to leg in one after the other. You can sell and buy the spread at one go. Many brokers and platforms let you do that. Ofcourse you can leg in one leg at a time if you want to.
3. You can buy the credit spread back anytime you want before it expires. It depends on what you want to do. You can buy it back the very next second or you can wait till it expires worthless - which is when you dont have to buy it if your underlying stock price is appropriate based on your spread.
4. Profit and loss - depends on what the underlying stock did after you sold your spread. Lets say if you sold a put credit spread and after that the stock tanked down. Then your spread will be at a loss. Similarly if you sold a call credit spread and the stock rallied, then you will be at a loss as well. Its more complicated than just this. It depends on how many days to expiry, what is the strike price of your short leg and the current stock price.
5. You can sell spreads just 1 day before expiry and make a profit. You can also sell a spread a month before and make a loss. Time does have a factor when you sell spreads (time decay works in your favor). But stock price is more important. Spreads are more forgiving than directionals (calls or puts).
I somehow feel that you are new to selling spreads. Take my advice and try it out in a sim account. If you really want to go live and start doing the action live, just trade with 1 spread quantity. That way even if you lose, you dont lose much. Its very easy to get greedy and sell 10 spreads and if the trade does not work out, you will have a large loss on your hand. I have experienced it personally. All the best!