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Credit vs. Debit Spreads

April 10, 2019

April 10, 2019

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Credit vs. Debit Spreads

Every options trader should have an understanding on the differences between credit and debit spreads. A spread trade, or combo trade, simply refers to trades with more than one “leg” (bought/sold option) to the trade.

Every options trader should have an understanding on the differences between credit and debit spreads. A spread trade, or combo trade, simply refers to trades with more than one “leg” (bought/sold option) to the trade. Credit and debit spreads refers to whether you pay or receive money to open the trade. 

Beginners must note, you can sell an option you don’t own.

To put the difference simply, a credit spread is an options trade where, upon entry, you sell one option leg for greater value than you buy another leg, and subsequently receive a credit. Inversely, with debit spreads, upon entry you buy options of greater value than you sell another, and therefore pay to enter the trade.

One of the most common debit strategies we teach is the “Bull-Call spread”. A “Bull-call” is where you buy a call option with a lower strike and sell a call option with a higher strike. Since calls at a lower strike are worth more than those at a higher strike in the same month, we will pay a debit for this spread. When we go to close the trade, we will sell it for a credit (unless it is worthless). For debit spreads with all legs in the same expiry month, and all legs either call or put options (not both), the maximum risk for the trade is the premium you pay. There will also be no margin requirements for these sorts of debit spreads.

More complex debit spreads with differences in expiry months or options types can still incur margin requirements, with some of the trades having strategy risk beyond that of the premium paid. 

One of the most common types of credit spreads that we teach is a “Bear-Call”. A “Bear-call” is where you sell a call option with a lower strike and buy a call option with a higher strike. Since calls at a lower strike are worth more than those at a higher strike in the same month, we will receive a credit for this trade. When we go to close the trade, we will buy it back for a debit (unless it is worthless). For credit spreads with all legs in the same expiry month, and all legs either call or put options (not both), the maximum risk for the trade is the difference between strike prices, minus the credit that you receive upon entry. There will also be a margin requirement for the trade, with the maximum margin requirement for same-month trades being the differences between the strike prices (where all legs are either calls or puts, not a combination of).

For each debit spread there will be a credit spread that matches the same outlook on directional price movements. However, the payoff mechanics will work differently. For vertical spreads (spreads in the same month with the same options type) a debit trade will have a cost to enter, with the maximum profit the difference between the strikes, minus the premium paid on entry. For vertical credit spreads, the maximum profit is the amount received upon entry of the trade.

The most common debit spreads that our clients place are “Bull-calls” and “Bear-puts”. The most common credit spreads our clients place are “Bear-calls” and “Bull-puts”. Anyone looking to learn more about the differences between credit and debit spreads, or to learn more spread trading strategies, should click here to get a complimentary trial for our Options trading platform.

 


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