Vertical Credit Spread Explained

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Vertical Spreads

The vertical spread is an option spread strategy whereby the option trader purchases a certain number of options and simultaneously sell an equal number of options of the same class, same underlying security, same expiration date, but at a different strike price.

Vertical spreads limit the risk involved in the options trade but at the same time they reduce the profit potential. They can be created with either all calls or all puts, and can be bullish or bearish.

Bull Vertical Spreads

Bull vertical spreads are employed when the option trader is bullish on the underlying security and hence, they are designed to profit from a rise in the price of the underlying asset. They can be constructed using calls or puts and are known as bull call spread and bull put spread respectively.

While they have similar risk/reward profiles, the bull call spread is entered on a debit while the bull put spread can be established on a credit. Hence, the bull call spread is also called a vertical debit spread while the bull put spread is sometimes referred to as a vertical credit spread.

Bear Vertical Spreads

Vertical spread option strategies are also available for the option trader who is bearish on the underlying security. Bear vertical spreads are designed to profit from a drop in the price of the underlying asset. They can be constructed using calls or puts and are known as bear call spread and bear put spread respectively.

While they have similar risk/reward profiles, the bear call spread is entered on a credit while the bear put spread can be established on a debit. Hence, the bear call spread is also called a vertical credit spread while the bear put spread is sometimes referred to as a vertical debit spread.

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Calculating Credit Spread from Debt Formula

papillonring

New Member

In the Stulz reading, Formula 1 should be used to solve Credit Spread (CS):

Formula 1:
CS = -[1/(T) x ln(D/F)] – rf

This formula is actually taken from forumla 2:

Formula 2:
D = F x exp-(rf + cs)T.

However, in the earlier chapter, I learnt that to calculate current Debt, I should use formula 3:

Formula 3:
D = (F x exp-rT) – Put

Why is put value not considered in Formula 1 when solving CS?
Apologies if you have to repeat this again. tried searching for similar question but I was returned with a number of posts.

David Harper CFA FRM

David Harper CFA FRM

It is a interesting direct connection that I have not seen made before (!). If you are interested, in order to verifying the reconciliation, I entered into modified Merton model (see rows 57-65, at the bottom) @ http://db.tt/AUhK5Rk

This uses the same De Servigny example of a Merton model. Specifically,
Face value of Debt (F) = $13,
Time (T) = 1.0 years,
Riskfree rate = 4.0%

And then, per Merton type approach:
Price of risky debt (D) = price of risk free debt – put option = $12.49 – 0.35 = $12.14

And using that price we can solve for an implied spread (Stulz, not really a Merton approach)
= LN(13/12.14) – 4.0% = 2.86% credit spread (s)

It’s a long way to show that these two approaches are not in conflict; they are just different approaches. The first uses asset volatility and option pricing (and therefore no real view on future expectation), the second (by discounting a risky return) does incorporate an expectation. I might summarize the difference as the first is based on volatility, the second based on on discounting (and therefore future expectation).

Discounted price = Merton-based (OPM) price:
F*exp[-(r+s)T] = F*exp(-rT) – p, where p = put option value, such that
F*exp(-rT)*(-sT) = F*exp(-rT) – p, and
F*exp(-rT)*exp(-sT) = F*exp(-rT) * [ 1 – p/F*exp(-rT)], and
exp(-sT) = [ 1 – p/F*exp(-rT)]

… I maybe didn’t find the most elegant relationship, but notice this last equation equates the spread with the put value (and the XLS verifies). Hope that helps rather than confuses, like I said, it’s really interesting to me b/c nobody has drawn the connection before!

Vertical Debit Spread

The vertical debit spread refers to a vertical spread whereby a net debit is taken to enter the trade. A bullish vertical debit spread can be constructed using call options and is known as the bull call spread. A bearish vertical debit spread can be created using put options and is known as the bear put spread.

Vertical Credit Spread

Vertical spreads can also be entered on a credit. See vertical credit spread.

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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