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What is a Credit Spread?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 01 November 2016
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    Conjecture Corporation
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A credit spread is the difference between the prices of two different securities involved in a purchase and sale. With credit spreads, the value or price of the option that is purchased will be less than the value of the security that is sold. The end result of the credit spread is the investor makes a small gain in cash balance with the set of transactions.

The key to increasing the cash balance in the investor account with a credit spread involves choosing the securities used in the spread option with great care. One common example is to make use a mix of securities that are currently considered to be bullish and bearish in the marketplace. That is, one security is considered aggressive and likely to increase in value while the other is considered to be somewhat stagnant and not anticipated to experience much growth in the near future. By combining a bull spread that uses puts with a bear spread employing calls, it is possible to achieve a nice profit from the sequence of transactions.

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Putting together spread options that will yield a significant influx of cash requires evaluating the credit spread thoroughly. In order to accomplish this, it is important to assess the current level of credit risk associated with the securities under consideration. Along with understanding the current status of the securities, the investor should also consider changes in the marketplace or other economic factors that could cause a shift in the current performance of the securities.

Failure to project the future performance of the two securities accurately may still mean the investor makes a profit and creates a higher cash balance in his or her account. However, if the security that is sold makes a dramatic increase in value over the short term, the investor may find that the small return gained from the credit spread strategy is eclipsed by the larger return that would have been realized had the transaction never taken place.

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