What is a credit spread and how is it different from selling naked options?

Question

What is a credit spread and how is it different from selling naked options?

AcadiFi · Accepted Answer

A credit spread sells a closer-to-money option and buys a further-OTM option as protection. For Kestrel Financial at $110:

Bull put spread:
- Sell $105 put for $1.80
- Buy $100 put for $0.60
- Net credit: $1.20
- Max profit: $120 per contract if Kestrel stays above $105
- Max loss: ($5.00 - $1.20) = $3.80 per contract if Kestrel drops below $100

The long put caps your risk, which is why margin requirements are dramatically lower than naked. Brokers typically require only the max loss amount, versus 20-30% of the underlying value for naked puts.

The trade-off is lower premium per dollar of capital risked. Naked puts collect the full premium but risk the full strike value; credit spreads collect less but risk only the width. On a return-on-risk basis, credit spreads often underperform naked options in calm markets, but they dramatically reduce tail risk. For CFA Level II, this is a classic example of the risk-reduction versus expected-return trade-off — the spread is a hedged version with a known maximum adverse outcome, which is critical for portfolio risk budgeting and VaR calculations.

What is a credit spread and how is it different from selling naked options?

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