When would you use a credit spread over a debit spread?

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Bull Call | Bear Put
Credit Spread vs Debit Spreads

When would you use a credit spread instead of a debit spread?

Debit Spreads

 

Debit spreads are directional options buying strategies where you are net paying for an options spread.

For example: 

Buying a put debit spread would be a directionally bearish position — buying a put option and then selling a put option at a lower strike price. 

Buying a call debit spread, which is a directionally bullish position — buying a call and then selling a call at a higher price. 

For most debit spreads, you want to enter during lower IV environments, generally. 

When entering a position where you are net buying options, you want to do so when implied volatility is super low – ex: IV rank of under 20.

When IV rank is very low and you enter a debit spread, one way to profit from that is if IV potentially increases.

With debit spreads, you are also more directional with your assumptions; stock will either turn around or continue in the same direction. 

The underlying foundation with debit spreads is that you want the stock to move.

Debit spreads can also be used for hedging purposes, because it offers quick exposure in one direction or another. 

Example: If you have several positions that are becoming too bearish and need some bullish exposure, you can buy a call debit spread, which effectively will give you exposure as soon as the market continues to move higher without experiencing lag time. You are generally buying these spreads around at the money strikes so as soon as the stock starts moving higher, you have immediate exposure towards that stock going higher. 

 

Credit Spreads

 

Credit spreads are a net selling strategy where you traditionally sell a spread out of the money. 

This gives you a high probability of success, but you are also potentially taking in a lower premium.

Ex: If the stock is trading at $100, you can sell the 105 call and buy the 110 call. 

Credit spreads are great in all environments:

 

Just because debit spreads work great in low IV environments, does not mean you should use them over credit spreads.

Even though IV can be low, that does not mean that the over-expectation of IV pricing, or IV edge, that you gain selling options disappears – it just gets reduced. 

So potential profit with expected returns is much smaller in low IV environments. 

Therefore, you can still trade credit spreads and sell options during low volatility markets you just want to scale back your position size. 

When IV is high, scale up and allocate more towards the trade. When IV is low, scale back the position size. 

Credit spreads are less directional in nature than debit spreads.

However, you can set up a credit spread to be bullish or bearish. 

But with a credit spread, you still have the potential to make money even if the stock stays the same or goes lower. 

Example: If the stock is trading at $100 and you sell the 95 put and buy the 90 put, the stock can stay at 100 and you make money. It can go down to 97 and you still make money. Or it can go up and you can make money. Therefore, it has less directional risk for an options trader as opposed to a debit spread. However, because you have less directional risk you take in less money. Ultimately credit spreads will pay more money, have lower draw downs, and higher expected returns.

 

Credit spreads are income-driven and react slower to the underlying market movements.

With credit spreads, since you are selling options and your income is capped, it’s generally slower to react to the market movement because it’s an out of the money option. 

Therefore, you do not necessarily realize the profits until much later in the expiration period. 

Where you end up choosing strike prices matters a lot in both credit and debit spreads — based on time and IV levels. 

You will ideally want to set up a debit spread so that the break even price is just around the stock price.  The break even price is determined by the spread width and the debit premium.

If the break even is just around the stock price, then it is possible that you break even or profit even if the stock price does not move.

If you have a 10 strike wide 95-105 call debit spread and the stock price is 100 ( in the middle ) the profit on the option is potentially 5 dollars ( 100 minus 95 ).  You will want to collect a premium of about 5 dollars.

If the stock price does not move at all, the short strike will expire worthless.  

The long call, however, will be worth about 5 dollars (  100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.

Building Blocks are combinations of buying and selling of calls and puts

If the stock moves in your favor and moves above the short strike, you will achieve maximum profit.  The maximum profit is calculated by the width of the strikes minus the debit you paid.

In this example, the width is 10 and the debit it 5.  So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.

If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade.  Maximum loss is simply the price of your debit premium.  In this case it is 5 dollars.

You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.  

Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread.

If the original debit was 5 dollars and you were able to get another 30 cents.  Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.

If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed.  Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide.  Your profit is based now on a strike width of 5 minus the debit which is now 4.7.

 

If the stock price does not move at all, the short strike will expire worthless.  

The long call, however, will be worth about 5 dollars (  100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.

You might not want to manage this trade if you are  at least breaking even,  It might be hard to move the short strike down for a credit and it might be harder to move it down and still pay for the expense of commissions.  This scenario will depend on whether or not you can move it down for a reasonable credit.  

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Checklist considerations

  • this management strategy at least will decrease the cost basis and maximum loss
  • If we roll the option for a debit, we will take on extra risk and possibly lock ourselves into a bigger loss
 

 

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