Credit and Debit Spreads

Trade What You Know

credit and debit
Debit and Credit Spreads. Pixabay.com

Question from a reader: I noticed in the Rookie's Guide you have a chapter on Credit Spreads, but not one similarly dedicated to debit spreads, straddles, etc. My question is, are there certain setups you stay away from entirely, and if so, is this why these spreads do not have dedicated chapters? 

For example, do you write credit spreads but not buy debit spreads? For example, I--at least at the present moment in my options career-- cannot foresee writing a short straddle, as it seems far too risky for me.

Moreover, I know a lot of people are crazy about Iron Condors, but I do not like to make trades based on a stock staying neutral or within certain parameters. My particular focus is on stocks that I have been watching for a long time, that generally have a higher volatility (I like the biotech sector), and where I can anticipate big PRICE shifts. I understand that each investor has different goals, but are there particular spreads you similarly avoid entirely? Thanks.

The Reply

Debit spreads are equivalent to credit spreads -- under specific conditions -- so it is not necessary to write about them separately. All you have to understand is what those conditions are.

Some authors do write about these strategies as if they were totally unrelated to each other. In reality, they provide the same profit/loss.

It is important that you tend to have a directional bias when you enter into a trade. That makes the credit (or equivalent debit) spread an ideal trade for you.

In my opinion, traders will do better if they choose one of the following, based on their way of looking at spreads. There is a psychological advantage for some traders to sell option premium, hoping that the spread position loses value and approaches zero. Others prefer to buy something and therefore are better off (again, psychologically, not financially) paying a debit to own a position and (hopefully) watch it increase in value.

As long as options are efficiently priced, there is no true difference between the following two spreads. [This is true when interest rates are low. When rates are high, and the cost of using money is high, then most traders prefer the credit spread, even though there is no advantage to one over the other because the cost of the spread takes the cost of money into consideration.]

For example, taking a bullish position on stock XYZ, you can:

  • Sell 1 Nov 100 put and buy Nov 90 put; Collect $2 in premium. This is a credit spread.
  • Buy Nov 90 call and sell Nov 100 call; Pay $8 debit This is a debit spread.

At expiration, when XYZ is

  • under 90, each spread loses $800
  • above 100, each spread gains $200
  • Between 90 and 100, the positions gain or lose equal amounts. For example, at $98.50, the put spread is worth $1.50 -- for a gain of $0.50 (or $50). The call spread is worth $8.50 for the identical gain.

Thus, buying a call spread is equivalent to selling a  put spread when the underlying, strike prices, and expiration date are identical.
Similarly, selling a call spread is equivalent to buying a put spread, with the same underlying, strikes, and expiration date.​ 

Straddles are VERY different because they come with essentially unlimited profit (or loss) potential.

I stay away from these strategies for the reason you stated: too risky. Please understand that these strategies can be handled by disciplined traders with skilled risk management in place -- but gap openings can destroy a straddle (or strangle) seller when the position size is too large. When buying straddles, time decay is too rapid for me. These are personal decisions and trading straddles if fine if you trade small size and understand how manage risk.

Iron condors are very similar to credit spreads. After all, the IC is the simultaneous sale of two credit spreads -- a call spread and a put spread on the same stock. However, if you trade stocks that you know well, it is better to sell only the call or put spread, rather than both. So once again, your trading style and tolerance for risk suggest that the IC is not for you.

Thanks for the question.