Debit and Credit spreads are called Vertical Spreads. It's a common strategy and the building block for other more complex strategies when trading options.
A Debit spread occurs when you buy one option and concurrently sell another option with a strike that is further OTM (out of the money) resulting in a debit (or cost) to your account. Both options are within the same option chain (same underlying; same DTE (days to expiration)).
A Credit spread occurs when you sell one option and concurrently buy another option with a strike that is further OTM resulting in a credit (or premium) to your account. Both options are within the same option chain.
Let's go through the most common questions about these spreads; first starting with the Debit spread.
· Do you pay for a Debit spread?
Answer: Yes. The amount paid is the net of the cost for the option you buy less the option you sell. This cost will reduce your buying power for other assets by the net amount.
· What is the total I can lose?
Answer: This is a defined risk strategy; you cannot lose more than the net paid for the Debit spread. However, keep in mind that at expiration, if the Long strike (the option you bought) is ITM (in the money) that your broker will automatically exercise it resulting in purchasing the underlying stock. If you want to avoid this, you must either sell the Long option before expiration, or contact your broker with an order NOT to exercise.
· How does a Debit spread affect my POP (probability of profit)?
Answer: The POP depends on the location of the Long strike and the net cost of the spread. The further OTM, the lower the POP. Generally, it is best to place a Debit spread ATM (at the money) in which the Long strike is ITM and the short strike is OTM; this will result in a POP close to 50%.
· Are Debit spreads easy to fill?
Answer: That depends. First is the question of liquidity; the more liquid (high volume and high open interest), the easier to get a fill. And second, the location of the strikes; it is far easier to fill a Debit spread ATM than either ITM or OTM, since that is where the most volume occurs.
· Who is selling me the Debit spread?
Answer: The major exchanges have spread books, and your Debit spread will be entered to the book. Anyone (retail trader, market maker, etc.) can take the other side of your spread.
What about the Credit spread? Let's apply the common questions.
· Do you get the Premium immediately?
Answer: Yes. While your account is credited for the premium, the account's buying power is reduced by the amount at risk.
· What is the total I can lose?
Answer: This is a defined risk strategy. The total you can lose is the difference between the strikes less the premium received. For example, if your spread is $5 wide (short Call strike $105; long Call strike $100) and you receive $1 of premium, then your max loss will be $400 (100 x ($5 - $1)).
· How does a Credit spread affect my POP?
Answer: The POP depends on the location of the Short strike; the further OTM the higher the POP. Depending on the volatility of the underlying asset, there will be an optimum balance between POP and premium received to maximize returns while reducing average drawdown.
· Are Credit spreads easy to fill?
Answer: It depends. Ease of fill depends on the same factors as described for the Debit spread (see answer above).
· Are Credit spreads better than Debit spreads?
Answer: It depends. If you are looking for a short-term directional trade, both type spreads are equivalent. However, if you are looking to hold till expiration and you prefer a high POP, then the Credit spread is preferred. Why? For the following reasons: First, if your position is profitable at expiration, you do not need to close the position (both options are worthless at expiration when OTM). Second, the POP for a Credit spread increases the further OTM the short strike, while the POP for a Debit spread increases the further ITM the long strike. Going further ITM with a Debit spread and you increase dividend risk on the short strike (risk of early assignment), plus you still have to overcome the cost of the Debit spread at expiration to realize a profit. And third, if you plan to convert your Credit spread into an Iron Condor (both Put and Call Credit spreads), the reduction in buying power is unaffected; this is not true for a combination of Put and Call Debit spreads, which will further reduce buying power.
In conclusion, I find Debit spreads useful for short-term directional plays ATM. However, I prefer Credit spreads for all other trades because of its flexibility to convert to Iron Condors with no additional reduction in buying power, and the alternative of letting the spread expire worthless without incurring any additional commissions or loss of premium.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.