The Credit Spread Strategy in Currency Options Trading
In my previous two articles I have explained in detail about strangle and Iron-Condor strategy for option selling. In this article I will go in details about next option trading strategy called “Credit Spread” strategy.
Credit Spread Option Strategy
This strategy involves buying of low premium option contract and simultaneously selling high premium option contract of the same expiry and in same quantities (both buy and sell) resulting in a net credit of spread premium into the account. This is a directional option selling strategy. It works best when market is trending and has more returns as compared to other strategies. The low premium option is bought to secure the high premium option. In case of trend reversal the low premium option would balance the loss in the position of high premium option sell.
Let us try to understand how it will work through a use-case. Let us assume that USDINR pair is trading at 73.40. Naturally, the ATM and ITM options premium would be high at the beginning of the month. It is all about the view point, now if the view of the trader is that the trend is going to be bearish or have tendency to fall then he will deploy Credit Spread strategy. He will sell either ITM or ATM call option of high premium and buy a call option of low premium for the same expiry. He can sell either 73.0 CE and buy 74.5 CE for the particular month expiry or sell 73.25 CE and buy 74.5 CE. Note that the number of lots sold should match number of lots bought. So if a trader is selling 10 lots of 73.0CE then he must buy 10 lots of 74.5 CE. This way the net credit would be created which will be deposited in the trading account. The gap between the two option contracts should be such that net credit created is reasonable and profitable. The buying of low premium option contract is financed from the sell of high premium option.
There are two ways to deploy credit spread strategy
Sell ATM Option and buy OTM option
This will offer you more credit of premium as ATM Options would have high premium thus the net credit created would be more. But more credit also means more loss as the bigger gap between two options will also mean more loss. If the trend reverses then the loss would be more. This will work best when the asset is in a strong trend. If there is a strong bearish trend then you can sell high premium ATM call and buy low premium OTM call and vice-versa if the asset is in a strong bullish trend.
Sell ITM Option and buy OTM option
This will offer more credit as compared to other strategies but lesser then the above method where we are selling ATM option. The loss in this case is less as compared to the above method. This method is deployed when the asset is in a mild trend. For example, if the USDINR pair is trending in downward direction but the trend is not sharp or strong then this method can be deployed. This will also work if the expiry happens at ITM strike price.
The above and below payoff graph shows that the risk is less while the reward is more in this strategy. If a trader sells 10 lots of a Call and buys 10 lots of a Call then the net credit would be Rs 11750 while the loss would be Rs 3200. I think that is a fair risk to reward while deploying this strategy. The total margin requirement for carrying out this operation for 10 lots would be approx Rs 29964.8
Note:- The above figures and illustrations are just figurative other factors should also be considered while calculating the margin requirement.
Technical Specification
Name: Credit Spread
Maximum Loss : Limited
Maximum Profit: Limited
Condition : Buy Low Premium Option and Sell High Premium Option of the same expiry and in same quantity
Ideal Condition: Mild to strong trend
Type: Directional Selling
Min Quantity Required : 2 (1 buy and 1 sell)
Conclusion
The credit spread option strategy works best when the asset is in a trend and has a direction. The opinion of the trader matters most in this case and the trader can benefit from the move in the asset by selling ATM or ITM options. Besides selling ATM or ITM option the trader also has to secure this sell operation by buying a low premium option. This will ensure that in case of trend reversal the loss would be restricted and managed by the bought option. The risk/reward ratio is fair as compared to other strategies and credit spread strategy provides more returns as compared to other option selling strategies. The margin requirement in case of USDINR pair is quite reasonable and anyone can deploy this strategy during trend by putting up Rs 30000 approx for a monthly expiry.
