In the world of equity options, there are two broad categories of spread trades; the debit spread and the credit spread. What are they and how are they different? In this article I will define each and touch on why a trader might use one over the other.
Before I can define a debit or credit spread, I must first define what is meant by the term “spread trading”. When trading options there are almost no limits to the types of trades that can be created. Most who are new to trading options will start by simply buying a long call or long put as a directional trade. Many investor have simply sold puts with the explicit intention of an outright stock purchase if the underlying price drops below the strike price of the sold put option. These three trades are commonly called naked options because there are no additional instruments to limit the potential risk of the trade. By contrast, a spread trade consists of at least two options and in many cases more than two options.
A debit trade is one in which the primary instrument is purchased. It can be a long call, a long put or even long the equity itself. As a directional trade, all of your investment is at risk. In order to limit the potential risk of the trade, another instrument will be introduced into the trade. In most cases that secondary risk limiting instrument will be of the same type as the primary instrument but it will be a sold option. The purpose of adding this risk limiting tool is to reduce the amount of risk that is in the trade. Typically, the credit received from the sale of the option is less than the debit incurred by the purchase of the long option. In a debit trade the risk of the trade itself is the amount of money spent for the entire spread trade. In other words, the difference between what you spent for the long option and what you were paid for the short option.
For example, if I were bullish on XYZ which is trading at $50, I might buy a long call with several months until it expires in the hopes that the equity will trend higher. I would pay a debit for this long call and to be profitable the equity would have to trend bullish. In order to reduce the amount of debit that I have in this trade, and the risk, I could sell a call option at a higher strike price then my long call. This would be a credit back to my account which would lower my overall cost basis, and therefore risk, in the trade. The trade would still require a bullish move to be profitable, however, I have reduced my risk exposure by lowering my cost basis.
Even though it is typical that a debit spread consists of long and short options of the same type, there are debit trades where both of the instruments are purchased. A trade such as a straddle or a strangle fits into this category.
Because debit trades are typically structured around a long option, they are best suited for trending equities. Some sort of directionality is normally required for this trade to be profitable. Not so for the credit trade.
The primary instrument of a credit trade is a short (sold) option. It can be either a short call or a short put. Because the risk of a naked call is theoretically unlimited and the risk of a naked put is quite high, we create a credit spread to limit the risk. By using some of the proceeds from the sale of the short option to purchase a similar type long option, we can limit the risk to the difference between the strike prices of the two options less the credit that we received when we sold the spread. For example, if I had a bullish expectation on XYZ which is trading at $50 per share, I might sell to open a strike 45 short put for one dollar. If I were to then by a long put at strike 40 in the same expiration series as the strike 45 short put, and pay $.50 for it I would have a net credit of $.50 for the spread trade. The risk in the trade would be the difference between the strike prices of the options, in this case five dollars, less the credit that I received when I initiated the trade, $.50. So the greatest risk in the trade is $5.00 – 0.50 which equals $4.50 per share. Unlike a debit trade where it the risk is paid up front, in a credit trade the risk is potential and not yet realized.
The amount of potential risk compared to potential reward in a credit trade is typically higher than the risk to reward ratio of the debit trade. So why would a trader pick a credit trade over a debit trade? The answer lies in probability and the number of trends optimized by the trades. A debit trade almost always requires a trending equity. It can be bullish or it can be bearish but the equity needs to move. By contrast, a credit trade can be profitable in several trends. Since the primary instrument in a credit trade is a short option, the passage of time in and of itself can take this trade to its maximum profit. The equity does not have to trend in order to be profitable. If the equity trends in the direction favorable to the short option the trade will be profitable and may offer the opportunity to close the trade early. So a credit trade typically can optimize three trends. That makes the probability of the trade going to a successful conclusion higher than that of the debit trade.
Debit trades optimize directional movement by the underlying equity. The risk in a debit trade is the amount of money the investor or has paid to initiate the position. The potential reward of the debit trade compared to its risk can be very high, however, directionality is almost always required for debit trade to be profitable.
A credit trade, by contrast, can also optimize a directional trend. Its broad appeal is due to the fact that it can also optimize a stagnant trend and depending upon its structure may even be able to be profitable in a contrary trend. Because of this higher probability and greater number of trends that this trade can optimize, the reward is typically much lower for the amount of risk taken on by the investor. In a credit trade the primary instrument is sold any risk limiting option is purchased to limit the amount of potential risk.
Both trades have their place in the market. The development of expectation for the underlying equity is the critical first step that will guide the investor in the decision-making process as to which one to select. They both have their place. You’ll need to paper trade and practice with both of these types of trades in order to truly appreciate which one to use when.