Credit spreads generally refer to rate differences between two related contracts, and the trading strategies that take advantage of such differences. More specifically, credit spreads can refer to either the difference in yields between a given bond and the risk-free instrument with identical maturity, coupon rate, etc, or credit spread can refer to the price difference between two different options on the same underlying security.

Q. So, this is a common phrase, but it two extremely different definitions, eh?
A. Very different. Let’s start with the one that relates to yield instruments. Here, the spread refers to differences in yields between a risk-free bond (pretending those exist) and another one that has exactly the same characteristics: maturity, payment patterns, etc. The difference between the two is called the “spread”.

Q. OK, and this is a very big area for traders to play, right, the widening and tightening of spreads?
A. Yes. If you think spreads are going to widen, you might, for example, go long a CDS instrument because the cost of insuring against corporate defaults will go up. Many traders specialize in exactly this sort of thing instead of just going long or short a particular bond.

Q. OK, and what’s the other kind of credit spread?
A. That’s an option strategy on equities, a totally different idea. This refers to the different prices on different options for the same underlying stock. So a call that is struck at 50 might have a much higher premium than a call that is struck at 45. The difference is called the spread.

Q. And then how does someone profit on that?
A. They can sell the high premium option, and buy the low premium option, pocketing the difference. That’s the “credit”. If the spread narrows, they’ll close out both positions and be a net winner.

Q. So those are two extremely different ways to use the phrase “credit spread”!
A. Yes. What they have in common is that traders are looking for the relative prices of two securities to change over time, which itself is, of course, a common pattern.

Q. Can normal investors try to do these things?
A. Many day traders do the equity option strategy, but its tough to play the yield version without a very big balance sheet.