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Credit Spread

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A credit spread is an option strategy implemented by the simultaneous purchase and sale of two options where the proceeds of the option sold exceeds the cost of the option purchased. To set up a credit spread, the investor looks for options of the same security with different strike prices and with the same expiration date. Whether involving puts or calls, a credit spread limits the risk or reward that can be earned. The maximum gain of a credit spread strategy is the difference between the premium of the option purchased and the one sold (i.e. net credit). The maximum loss of a credit spread is the difference between the strike prices minus the net credit received. A credit spread is also called a vertical spread.

For example, assume XYZ, Inc. trades at $64, a credit spread in XYZ January calls may be established by selling a 65 call for $3 and purchasing a 70 call for $2. The credit spread of $1 ($3-$2) represents the maximum profit that may be earned. The maximum loss of $4 ($5 - $1), represented by the difference in strike prices minus the net credit, would be realized if XYZ were trading at 70 or above at expiration.

In fixed income securities, a credit spread refers to the difference between the yield of Treasury and non-Treasury securities that have comparable maturity but different quality ratings. This type of credit spread is expressed in basis points. Investors will examine a credit spread as an indication of risk in the marketplace between a relatively risk-free Treasury security and a comparable-maturity security issued by another entity (e.g. government, corporation, or municipality).

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