Credit spread (options)
Okay kiddo, so imagine you have two friends. One of them, let's call her Lucy, is very responsible and always lends you money when you need it. The other one, let's call him Timmy, is not so responsible and sometimes forgets to pay you back.
Now, let's say Lucy agrees to lend you $10, but she wants you to pay her back $11. Timmy also agrees to lend you $10, but he only wants you to pay him back $9.
The difference between what Lucy wants you to pay her back and what Timmy wants you to pay him back is called the credit spread. In this case, the credit spread is $2 - the difference between Lucy's $11 and Timmy's $9.
In the world of options, a credit spread is similar. Instead of borrowing and lending money, people make bets on the prices of stocks. One person thinks a stock will go up, while another person thinks it will go down. They make a deal where the person who thinks the stock will go up sells a "call" option to the person who thinks it will go down.
The "call" option gives the buyer the right to buy the stock at a certain price, called the "strike" price. The seller gets paid for selling the option, but if the stock price goes up above the strike price, they might have to sell the stock at a loss.
To protect themselves, the seller might also buy a "put" option - which gives them the right to sell the stock at a certain price. This is where the credit spread comes in. The seller might sell a call option with a higher strike price than the put option they bought. This creates a difference in the amount of money they get paid - like Lucy and Timmy lending money with different terms.
If the stock price goes down, the seller gets to keep all the money they were paid by the buyer of the call option. If the stock price goes up but not above the strike price of the call option, the seller still gets to keep some of the money, but not as much as if the stock price went down. If the stock price goes above the strike price of the call option, the seller might have to sell the stock at a loss, but they still get to keep the money from selling the call option.
This credit spread strategy can help sellers of options manage their risk and make money in a changing market. But just like Lucy and Timmy, different buyers and sellers will have different terms when it comes to options, and it's up to each person to decide what works best for them.
Now, let's say Lucy agrees to lend you $10, but she wants you to pay her back $11. Timmy also agrees to lend you $10, but he only wants you to pay him back $9.
The difference between what Lucy wants you to pay her back and what Timmy wants you to pay him back is called the credit spread. In this case, the credit spread is $2 - the difference between Lucy's $11 and Timmy's $9.
In the world of options, a credit spread is similar. Instead of borrowing and lending money, people make bets on the prices of stocks. One person thinks a stock will go up, while another person thinks it will go down. They make a deal where the person who thinks the stock will go up sells a "call" option to the person who thinks it will go down.
The "call" option gives the buyer the right to buy the stock at a certain price, called the "strike" price. The seller gets paid for selling the option, but if the stock price goes up above the strike price, they might have to sell the stock at a loss.
To protect themselves, the seller might also buy a "put" option - which gives them the right to sell the stock at a certain price. This is where the credit spread comes in. The seller might sell a call option with a higher strike price than the put option they bought. This creates a difference in the amount of money they get paid - like Lucy and Timmy lending money with different terms.
If the stock price goes down, the seller gets to keep all the money they were paid by the buyer of the call option. If the stock price goes up but not above the strike price of the call option, the seller still gets to keep some of the money, but not as much as if the stock price went down. If the stock price goes above the strike price of the call option, the seller might have to sell the stock at a loss, but they still get to keep the money from selling the call option.
This credit spread strategy can help sellers of options manage their risk and make money in a changing market. But just like Lucy and Timmy, different buyers and sellers will have different terms when it comes to options, and it's up to each person to decide what works best for them.
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