In options trading a credit spread is an options play where a trader buys one option and sales another option contract of the same stock and expiration but at different strike price levels. This type of option play construction attempts to make a net profit when the price spread between the two different options gets closer together leading to a net profit from the difference in the short and long options.
Option traders get paid a net credit when they open this option play with the difference between the prices when both selling one option and buying another, they want to see the price spreads get smaller, converge, or simply both expire to keep or grow the net profit. While an option trader would need to pay a premium to open a debit spread they get paid to open a credit spread. A spread getting closer together or converging means that the short option in the play could even be close to being in-the-money at the expiration date but still at a less amount than the net premium paid when opened and the trade is profitable. This would be by a smaller amount than the most that could be gained if both options in the credit spread expired worth nothing, as both expiring worthless would lock in the maximum credit for this option play.
Option brokers margin requirements for option credit spreads are much less than they are for uncovered options with unlimited risk. A credit spread is an option play with the long option acting as a hedge for the short option. It is not possible for the account to lose more money than the margin that is required at the time the play is opened because the loss is capped.
A bullish credit spread refers to an option play where the value of the spread position decreases as the price of the underlying stock rises. A bullish credit spread is constructed with puts options.
A bearish credit spread refers to an option play where the value of the spread position increases as the price of the underlying stock falls. A bearish credit spread is constructed with call options.
This option play is best suited for range bound markets and the profit from this option play comes from the variance in premium between the option contract bought and the option contract short.
The maximum gain is equal to the net credit occurs if both options expire out-of-the-money.
The maximum loss is difference in strike prices minus the net credit that occurs if both the options expire in-the-money.
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