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.
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.
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.)
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.