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Debit Spread VS Credit Spread

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Debit Spread VS Credit Spread

There are plenty of different trading styles out there for every kind of options trader, whether they are conservative or aggressive. So when it comes to trading option spreads, which style of trading suits your potential better as an options trader, selling a spread and receiving an upfront credit for your trade while accommodating risk, or buying a spread on a debit and receiving the potential to multiply your gains? If you don’t know and you’d like to figure it out, ask yourself a couple of simple questions before you decide to go with one strategy or the other.

Debit Spread VS Credit Spread
Debit Spread VS Credit Spread

Do you prefer gathering your gains upfront with a higher chance that you will make money but a lower potential for profit? If you are the kind of trader who likes to trade with probability on your side, then credit spreads are most definitely for you. Credit spreads typically rely on making a profit when every leg of the spread expires worthless. Since around 80 percent of all options traded fall into this category, selling a credit spread definitely means having the wind of probability at your back in a trade.

However, be warned, as since you have the advantage of probability, it usually means that if you are wrong, you stand more to lose than you stand to gain. In other words, losing hurts a credit spread trader more than winning benefits you. You are expected to win a credit spread, and if you don’t you probably did something wrong. Just keep this in mind before you start placing 10 or 20 contracts down and expecting everything to just work itself out.

Or do you prefer making an investment in a trade with the hopes of realizing a profit when you close out your position? If you are the kind of trader who is good at sniping trends and can manipulate on options trade to your benefit in them, debit spreads are most definitely for you. With debit spreads, you make your largest possible loss up front at the start of the trade, so your losses are easy to calculate. And if you manage to win a trade, you can multiply the money you originally invested and make a serious killing.

However, be warned, as since you have the advantage of winnings potential at your side, it means that even if you manage to win a certain number of trades, most trades will be rigged against you and will not yield you a profit. You have to factor in your wins versus your losses when you trade debit spreads, and trust me, there will be a lot of losses.

So before you decide whether you’d rather play a credit spread or a debit spread, ask yourself a few basic questions:

  1. Do you prefer greater probability or greater potential for profit when making an options trade?
  2. Do you consider yourself conservative or aggressive when trading options?
  3. Do you mind carrying risk in an options trade in return for an upfront credit or would you prefer to carry profit potential in return for an upfront fee?

Option Spreads – Debit Spread VS Credit Spread

People who trade options often will engage in trading spreads. A spread is the buying and selling of the same type of option. A Call Option spread is buying and selling (writing) call options. A Put Option spread is buying and writing puts.

The purpose of engaging spread trading is to either make money on the premium difference (money spent and received) or to earn profit on the options themselves being traded or exercised.

Debit Spread VS Credit Spread?

There are plenty of different trading styles out there for every kind of options trader, whether they are conservative or aggressive

A debit spread is when the options that are bought and sold result in a loss on the premiums. The investor has spent more for the option purchased than the option shorted.

An example of this would be:

Long (buy) 1 ASD SEP 40 CALL@4 and Short (sell) 1 ASD SEP 45 CALL@2

This is a debit spread since the $400 paid exceeds the $200 received. There is a $200 Debit on this spread. The investor in this case is looking to make a profit on the future value of the options. Since these are call options, the investor is bullish on the market (wants the market on ASD to rise).

The market rising will allow the investor to take advantage of the increased premium or to exercise the options. The long option allows the investor to purchase the stock at 40 and the short option carries an obligation to sell at 45. If these were to happen, the person could make 5 points on the stock (strike price difference) minus the initial debit loss ($200). This equals the maximum gain potential ($300). The maximum loss is if both options expire worthless, resulting in a $200 loss.

A credit spread works the opposite way. The investor is looking to gain on the premiums and then is hoping the options expire worthless. Using the same example above, the numbers are the same, but the gain and loss would be reversed. The person would be Long the 45 paying $200 and Short the 40 call, gaining $400. The $200 is now a credit and is the gain. If the options were exercised, the 5 point difference in the strike prices would be a loss (buying at 45 and selling at 40). The trader would be bearish on the market for a call credit spread like this. Trading of credit call spreads is higher in a bear market.

Vertical Spread

A vertical or price spread is when the strike prices are different, but the expiration months are the same. The above examples would be considered vertical spreads.

Horizontal – Calendar Spread

A horizontal spread is when the strike prices are the same, but the expiration months are different. The trader can make money on this type of spread because even thought the strike prices are the same, the option with the longer expiration month will have a higher premium, so there is still a “spread”.

Diagonal spread

When a spread has months and strike prices that are different, it is defined as a diagonal spread. The options are vertical and horizontal at the same time.

All in all, spreads are fairly conservative – as far as options are concerned. A long position is covered by a short position, so large or unlimited losses do not normally occur.

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