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Thursday, May 3, 2012

Debit Spreads vs. Credit Spreads - Vertically speaking

I finally had another big Aha! in Options Trading.

It takes SO long to learn this stuff, as in knowing it right off the top of the head. At least it does so for me.

I've pretty much got the Credit Spreads down pat, but then I began to ponder the Debit Spreads. Mind you, these are Vertical spreads with the same expiration months. (I'm not ready to tackle Calendar spreads in depth just yet).

I couldn't quite figure out WHY you would want to do a Debit spread (instead of a credit spread) when it

1. costs money to do so, and

2 you need to buy out in time (theta works against Debit spreads)

3. then you have that wait for things to happen. (depending how far out your expiration).

Whereas Credit spreads are wham bam~! One week or one month and it's all over, and you've got the money in your pocket to begin with.

So what's the point? Why would I use one and not the other? Why doesn't anyone ever compare them?

So I had a pow wow with one of my trading divas today, Linda, and she's very smart and we got into it and figured it out. I learned a lot out of the session and I want to share what I learned. (it probably isn't the whole of it, but it's a start).

It makes the whole picture SO much simpler if you just compare them. In both trades you buy one option and sell another.

CREDIT SPREADS

Primary Instrument: (option) The Short Call or Put

Secondary (insurance) The Long Call or Put

The Short is sold out of the money,(OTM)the Long is bought further out of the money,(OTM) thus the premium for the Short is in excess of the cost of the Long, so you pocket the difference. A credit in your account when you put on the trade.

Maximum Gain: The credit in your account when you put on the trade.

Maximum Loss: (The Strike Price of the Short ) minus (The Strike Price of the Long) less the Credit in your account when you put on the trade. (the broker holds this maximum loss as margin until the trade is over).

Expiration choices: Theta works in favor of Short instruments, so the shorter time, the better. Weekly or Near Month are the best.

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DEBIT SPREADS

Primary Instrument : The Long Call or Put

Secondary (insurance) The Short Call or Put

The Long is sold at the money,(ATM),even in the money,(ITM) and the Short is bought one level away out of the money, thus the premium for the Long is in excess of the cost of the Short, so you PAY the difference. You are charged for the difference in premiums.

Maximum Gain: (The Strike Price of the Long) minus (The Strike Price of the Short) less the Cost of the debit to your account when you put on the trade. (there is nothing held by the broker for margin).

Maximum Loss: The debit taken from your account when you put on the trade.

Expiration choices: Theta works against Long instruments, so the longer the time, the better. Minimum of 45 days to 90 days is best. (you do not have to hold the trade that long, but that will keep Theta at bay until the last 30 days.)

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You will notice that things work in reverse between these two trades.

But take a closer look at a comparison of the Maximum Gain. You can earn MORE with Debit trades. It just takes longer.

Take a look at the Maximum Loss: The losses are HIGHER with Credit trades if they go wrong.

So, it would appear that debit trades make more sense than credit trades, but do they?

Not at all.

Would you like to take a chance on Priceline (PCLN) with a trade that didn't expire until July? The world could blow up (or down) with that crazy stock in that time. But it pays great premium and has a lot of action. There's money to be made there.

Whereas a steady stock like Intel (INTC) with its gradual uptrend for many months might be a perfect candidate for a debit trade that ended in July.

I would rather do a weekly credit trade on PCLN, grab my money and run, and do a debit trade on INTC and make more, risk less, and sleep well over the long weeks it takes to get there.In other words, there's a use for both trades, depending on the stock and your expectations of it.

As I said, I have a lot more to learn, but at least this question is now much clearer. Why on earth would I want to use a debit spread in some cases instead of a credit spread? Well, isn't it obvious?

If not, send me questions, please. I learn by answering them.

PS. My mentor Kris Maynard, upon reading this post, added this very important information: I would only add one little, but important, item: In a debit trade one must be correct about three things - the trend of the underlying; the timing, and the magnitude of the move. A credit trade, I find, is a bit more forgiving in that you can make money in a stagnant market. Positioned properly, one can even make money if the trend goes against the trade. This is why I much prefer credit trades. ##

19 comments:

  1. The credit & debit spreads are the same trade, you can use each for the same purpose. The debit spread does not necessarily need to be OTM, just like credit spreads do not need to be ITM.

    Example:
    AAPL SEP 550/545 Bull Put credit spread
    Credit $95 / Max Risk $405

    AAPL SEP 550/545 Bull Call debit spread
    Debit $395 / Max Profit $105

    Similar to what you said, they are mirrors of eachother, both have the same profit/loss mechanics, its just a matter if you'd prefer to pay now, or pay later...

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  2. Thanks for commenting. Good to hear from you. Everything I've learned indicates that the shorts on credit spreads MUST be
    Out of the Money, (or get assigned) thus the longs would also be OTM. I suppose the strategy for deliberately getting
    assigned could be used, but then why do a spread on the put side, anyway?

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  3. Your absolutely right, if ITM, you'd have to close out of your position before expiration. But an (initial) ITM bull put spread is equivalent to a bull call spread, with the intention that it goes OTM. Anyways, the point was just anything you can do with a debit, you can do with a credit, and anything you can do with a call you can do with a put. Great blog by the way, and be careful with the weeklies.

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  4. Hi,
    I came across your blog when I was looking for information on doing weekly credit spreads. I am also learning options trading and at the moment credit spreads seem like my cup of tea. Your blog has lots of great information, especially the recent ones on the iron condor.

    Just my two cents on the debit spread here. From what I've understand so far, debit and credit spreads at the same strike prices are basically the same. For debit spreads, the further ITM you are, the higher the probability of success but also the lower the profits. A call debit spread that is several strike prices ITM will profit if the stock stays above the long call. Similarly for credit spreads, the further OTM you are, the higher the probability of success but also the lower the premium collected. A put credit spread that is several strike prices OTM will profit if the stock stays above the short put.

    One difference though is that you can leave a credit spread to expire if it is safely OTM, but not for debit spread since they are ITM, so perhaps some savings on commissions?

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  5. Hi, thanks for stopping by. It's interesting because I've never heard anyone suggest that I buy debit spreads ITM. They've always said ATM or one level OTM, but what you're saying about deeper into the money is interesting. (and logical, though they would cost a lot more?) I'm going to have to ask some of the coaches I still talk to about that. Thanks!!

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  6. Hi, if you take into account the margin requirement for the equivalent credit spread, I think the profit/loss for both should be about the same (ignoring commissions and possible small differences in exercise price). I'm still studying these things so do correct me if I'm wrong, tks!

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  7. No, I don't think that's true.

    Credit spreads: Max Reward: Amount of credit received
    Max Risk: Spread between strike minus the credit received.

    Debit spreads: Max Reward: Spread between strikes minus the debit paid.
    Max Risk: amount of debit paid

    This means you can make a lot more (potentially) on a debit spread for less risk. But you don't get the money up front,
    and the probabilities are not as good as OTM spreads. Right?

    ReplyDelete
  8. Why aren't the probabilities not as a good as OTM spreads? You can setup a debit spread to still be long theta and same advantage of time passing. There is also no need to exit the position before expiration like someone mentioned here. Just let both legs to automatically exercise.

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  9. Well, if you want to PAY very high premium to buy ITM debit spreads, yes you don't need to exit the position before expiration. (providing the market stays bullish, that is). But the higher your risk, the higher the probability of success, that's just the truth of it, and if you do the math, you will see that you make more money with credit spreads. In fact you make more money with naked options, truth be told.

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  10. ok, the problem that i see on the credit spreads (and on all options trades, but credit spreads seem worse to me), is the bid/ask. i've seen the b/a make the further otm option cost more than you can sell the closer to the money option. of course you can leg in, but with legging in (unless you have A LOT of money in your account) you have to do the long leg first, and if the market drops before you sell the short leg you're screwed. any thoughts?

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  11. I don't believe you are correct. Options get less and less expensive as they go out of the money (just look at your option chain). The premium is higher atm, which makes debit spreads expensive, and otm credit spreads need some volatility in order for the premium to worth selling. I don't ever leg into spreads; they should be put on and taken off as spreads at the same time (except in very special circumstances). It is true that credit spreads require margin whereas debit spreads require none. But I think of it as "collateral" for the cash you are getting up front. And if you do the right homework, you can find credit spreads that require very little margin in the right market conditions.

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  12. 1630.00 2.20 +0.20 1.85 2.40 2.35 1.60 226 34,417 Trade | Watch | Calc | Detail
    1635.00 1.70 +0.30 1.30 1.85 1.75 1.20 784 14,179 Trade | Watch | Calc | Detail

    the above is from spx may call options chain a few minutes aqo. the b/a colums are # 4 and 5. i have been told, and have seen it happen, wherein, when you sell, you will qet the bid price, and when you buy, you will qet the ask price.
    so, in the case above, you would sell the 1630 for 1.85 and buy the 1635 for 1.85 this will qive you a break even instead of a credit, even thouqh you are sellinq the closer to the money and buyinq the further out of the money. you will of course lose on this particular trade.

    May 1630 / 1635 Call 0.10 1.10 1631.10 $390.00 $110.00 354.55% Trade | Watch | Calc
    here is the same trade, but puttinq the spread on as a spread aqain, accordinq to some, you will be stuck with the bid price for a credit of .10, touqh to make money.

    maybe i'm not seeinq somethinq here, or maybe there is a better way to put this credit spread on?

    p.s. i aqree with your statement on sellinq naked options, but of course unless you have a lot of money in your account, you are not allowed to trade them.

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  13. In my experience the "closer to the money option" (which you are selling) has a larger BID price than the next option further away from the money. The only time the prices are the same are wayyyy out of the money, or in a market that is in some crazy movement. In the case you've provided, I can't comment. When I got and look at those prices on my own chain, they are very different than this. 1630 has $1.10 Bid price and 1635 has $.90 Ask, so your premium would be .20 cents.

    When selling spreads, you are free to roam around and choose the premium you want...you can expand the legs (ex. 1630 and 1640) if you want to expand the risk thus increasing the premium. But the problem you have presented above has NEVER come up in my own trading. I believe you, but something is very odd about this situation. I've never even heard anyone mention such a situation until you did. ??? Sorry, can't explain your chain?

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  14. i have run into this b/a problem a lot on the spx call options. maybe my difficulty is in the fact that i only trade spx options. i have a qood feel for the spx market flow, tops/bottoms. i have been thinkinq of tradinq usinq stock options. i will check those out and see if i qet better b/a. thanks for the help. i'll stop back and let you know if i find somethinq that looks better usinq just stock options...thanks!

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  15. Hello Beverly - Glad to have found this discussion. Thanks for these topics!

    After a couple of years of calls and puts, I have been exploring vertical spreads. The way I see it, if the stock is OTM at expiration then nothing happens and you've made a little money from the credit spread and lost a little to the debit spread. If the stock is ITM then one stands to make a little more money from the debit spread. So if the stock outlook is bearish, only then does it make sense to do a credit spread.

    Cheers - Lisa

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  16. Hi Lisa, Thanks for reading.

    You are correct on the credit spread. If it stays OTM, you keep the credit. But depending on how far OTM you sell the short,the stock can go up, down or sideways...and you still keep the money. The movement on this stock price needs to be contained by the short strike price.

    Whereas with debit spreads, It is much more a directional bias. You are buying one leg ITM and selling one leg OTM (only to reduce your cost) and hope that the stock goes in your direction. If BOTH legs go ITM, you make your max profit doing an
    exercise/assignment tradeoff. The movement on this stock price can go as crazy as it wants, (in your direction) and you will still make the difference in the strike spread less what you paid for the trade.

    Thanks so much for reading and commenting!

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  17. Great Post! I'm still trying to wrap my head around credit spreads but I had the same question as to how the two differ. A Google search brought me to your site. Thank you for blogging. I'll read some more tonight. :-)

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  18. Let us know your thoughts, or ask if you have questions. Lots of input here! (thanks for dropping by)
    Bev

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  19. iTM debit spread profit from the passage of time and also from drop in implied volatility. No price movement is needed for this. In that regard they act like OTM credit spreads. The reward to risk ratio is usually better ; it's not uncommon to have to risk 500 to make 50 on a credit spread;,that would be unusual with a properly constructed debit spread. And being short gamma is no fun when stock price is moving strongly toward the credit spread short strike!

    ReplyDelete