Debit and Credit Spreads

Today we are going to explain the difference between a credit and debit spread. Overall, it is a simple concept, but must be explained before we continue talking about spreading risk.

Learning to Speak Optionese: Debit and Credit Spreads

With every spreading strategy there are two different setups, the credit spread or the debit spread.

A credit spread is created when you sell a call or put and buy a call or put of lesser value. Thus when you set up the spread you take in a net credit. If you're a bull you'll sell a put and buy a cheaper put. If you're a bear you'll sell a call and buy a cheaper call.

A debit spread is created when you buy a call and sell a call of lesser value. To open the position you must pay out a premium, or 'debit.' This is the classic spread I talked about when describing bull and bear spreads. Generally, people tend to open debit spreads. However, both types of spreads offer different advantages.

Which Spread Suits You?

Although debit spreads are used most often, you might prefer to use a credit spread. Let's start by talking about the advantages of using a credit spread.

Credit spreads make money when the trade moves in the direction you anticipated, which is to be expected. On top of that, if the underlying stock sits and does nothing all the way into expiration you make money off of the time decay! This is the sort-of double whammy that makes credit spreading very attractive. In two out of three market environments, credit spreads make money; it's good to have the odds on your side! Also, credit spreads don't cost anything to set up. Because you are taking in a credit, you don't have to pay any money to open the position! A lot of people like the idea of this, but I believe this is often deceiving. What you must have to set up a credit spread is margin (money in your account to back up the potential loss.) You must meet the margin for the maximum loss your position can suffer. What is the maximum loss? At expiration, your max loss is the distance between the two strike prices minus whatever time premium you received, (in the case of a call spread, higher strike price – lower strike price – time premium). This can be a substantial amount of money! If the spread between the strikes is a dollar you're talking about 100 bucks per spread, but more likely it will be 5, a whopping 500 dollars per spread! For this reason, I tend to stay away from credit spreads. I am not saying that credit spreads aren't great, they are - I even trade a particular strategy revolving around them – however, under most circumstances they are a bit too risky for my taste.

Generally, I create debit spreads. Debit spreads suffer from time decay, and if the position does not move in your favor, you can lose all the money you originally put out to open the position. Another problem I often have with debit spreads is liquidity issues with the call or put I am selling (the one of lesser value), I often ended up overpaying to open the position (buying at the ask for one call/put, selling at the bid for the lesser call/put), and then overpaying to close the position! Despite this, when the options have enough liquidity a debit spread is a great strategy to minimize capital exposure.

Overall, both credit and debit spreads offer unique opportunities; although, I prefer debit spreads you may prefer the prospects of credit spreads. Both spreads have their perks and pitfalls, and they can be rather quirky. I recommend experimenting with both types of spreads in a virtual account before you actually begin trading them. Tomorrow we're going to talk a bit more about spreading, and later this week we'll move on to talking about trade adjustments and how you can hedge and protect positions using options.

Until next time,

Spencer Sundahl