Debit and Credit Spreads Trading
In this post:
- What is a defined risk strategy that is cheaper than buying a long call/put?
- What are debit and credit spreads?
- What to do when you want to go long and enter the trade in the direction of the trend?
Many traders come to us with experience trading stocks, and possibly calls or puts. However, learning about more complex options strategies, such as credit and debit spreads, can be a daunting task at first. I wanted to do a quick summary on this topic because once you know the ins and outs of these trading strategies they can be incredibly beneficial.
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A Video to Debit and Credit Spread Trading
Debit vs Credit Spreads
If you feel that trading options still seem a bit out of reach, you may want to look into debit and credit spreads as they can be a great strategy to ease into the options trading business. Relatively speaking, they can have a high potential for rewards with fewer risks associated. But understand, nothing in the market is without risk and a great deal of planning and research needs to be conducted in each trade. With that being said, let’s explore debit and credit spreads, which have helped me pave my path to success.
Debit Spread Strategy (verticals)
Debit spreads are placed when you want to go long and enter the trade in the direction of the trend. These are placed in instances when buying a long call option or put option is of interest, but a spread is chosen due to the benefits of a spread. When you purchase a debit spread, you’re buying a premium for the long option, and selling a second option against it to reduce your cost basis, lower theta decay, and neutralize volatility.
Benefits of Debit Spreads:
- It’s a defined risk strategy that’s cheaper than buying a long call/put.
- A debit spread will lose less money than a long call/put if you’re wrong. But you’ll also make less money if you’re right.
I prefer using debit spreads when the market is volatile because they are easier to handle than long calls. I also use them regularly because of the cost, and therefore the risk associated with them. Using a spread, instead of a long call, can cut the cost basis in half. Of course, there is a tradeoff here. When you cut down your cost basis, you also put a cap on what you could possibly gain. But, these numbers are there for your viewing when entering the trade. Danielle would much prefer a spread, set up as a 1:2 risk-reward ratio, with limited risk (the debit paid) than paying an extraordinary amount for just a call, that is going to be more volatile.
Credit Spread Strategy (vertical)
Now onto credit spreads. Credit spreads are placed when you want to sell premium versus buying premium (as with long options and debit spreads), and it collects theta over time as it decays. You’re selling an option, and then buying a long option against. This is for protection against assignment and to define your risk. If you’re bullish on a stock, you can sell put credit spreads. If you’re bearish, you can sell call credit spreads.
Benefits of Credit Spreads:
- Way to trade directional moves.
- You can adjust the width of the spread and contract amounts to create a risk/reward ratio that you’re happy with. For example, John Carter, Founder of Simpler Trading and one of my trading mentors, likes risking one to make one.
- If you’re betting on a directional move but the stock moves sideways, you’ll still make money.
- If you’re betting on a direction move and you’re wrong, you used a defined risk strategy, and most likely lost less money than you would’ve if you bought long options.
Selling spreads is beneficial because they are more conservative than straight long calls or puts, and debit spreads. When entering a trade for a debit, you’re risking the debit you spent. However, when entering a trade for a credit, you’re actually taking in credit, to take advantage of one of the key facets of options – the fact that they decay and lose value until they expire.
By selling options you think will get closer to expiration, and be valued less than they are currently, you can enter into a conservative trade that will (ideally) slowly move in your favor over time.
Checking Your Risk
The great part about selling credit spreads is that they can easily be used in any size account, small and large alike. Spreads can be adjusted according to how many expiration days they have, how wide the spread is, and what strike price you’re selecting. All of these factors will impact the credit you receive, and therefore, how much risk you take on.
You can adjust the width of your spreads to determine how much you’re willing to risk. For example, when I was learning to trade from John Carter, he was often selling credit spreads $10 wide. Due to the fact that he had a much larger account than I, I would adjust those spreads to have a width of $2.50. This gave me a similar trade, with much less risk, that was appropriate for my small account.
When putting on a vertical, think of each vertical as one trade – put them on and take them off together, especially when you’re new. When you close one-half of the spread, it changes your risk profile.
When traders come to Simpler Trading, they are often surprised that we like to sell credit spreads, either at or in the money. John teaches this method, and it’s something Danielle has adopted as well, due to the 1:1 risk/reward ratio on these trades. The position sizes according to the max loss they are willing to incur, and they don’t risk more than they are willing to lose.
Calculating Profit Targets
Generally, John likes to target 80% of max profit, and then he’ll take off the trade. A more conservative profit target is 50% of max profit. But, how do you calculate 80% of the max profit? Below you’ll find out the calculation for both credit spreads and debit spreads.
Credit Spread Max Loss
Let’s say you’re selling a $5 widespread for a credit of $2.50. Your credit spread max loss is always the width of the spread, minus what you took in as a credit. In this case, that’s a $5 credit spread max loss. This trade would give you a 1:1 risk-reward ratio.
Credit Spread Max Profit
The max profit you can get is $2.50 because that’s the credit you took in when you sold the spread. To find 80% of $2.50, you multiply 2.50 x 0.80 which equals $2.00. Then, subtract your credit by 80%. For instance, $2.50 minus2.00 equals to $0.50. Therefore, if you’re attempting to take your spread off at 80% of max profit, you could set a Good till Cancel order at $0.50, and wait for theta decay and price action to work in your favor.
Since you’re selling premium with the hope that it’ll decay and go straight into your account, the hope is that you can buy back the spread for less than you sold it for, to exit the trade with a profit. In the case that the trade goes against you, you’ll have to purchase it back for more than you sold it for, creating a losing position in your account.
In the case of a debit spread, you’re purchasing premiums versus selling it. Your max profit is going to be the width of the spread. For example, you could purchase a debit spread for $2.50, which is $5 wide. The max you could sell it for is $5.
Debit Spreads Max Profit Calculator
To calculate the max profit, you take $5 and multiply it by $0.80. The calculation is $5.00 multiplied by0.80 which equals $4.00. Therefore, if you pay $2.50, and you’d like to take the spread off at 80% of the max profit at $4.00, you’re hoping to make about $1.50 on the spread. The most you can lose is the amount you paid. You need the price to rise in value so you can sell it for more than you bought it for. If it loses value, you lose money.
Entering and Exiting Orders
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Debit and Credit Spreads FAQs
Q: What is a credit spread?
A: A credit spread is when a trader writes or sells a high-premium option while at the same time buying a lower-premium option. The premium gained from writing the option should be greater than the premium paid for when buying options. This strategy will give the trader a credit, however, the net profit they receive is the net premium.
Q: What is a debit spread?
A: Debit spreads are the opposite of credit spreads. For instance, it involves buying an option with higher premiums while selling options with lower premiums. This strategy will entail the trader’s account be debited, so that way their position will be used to offset the cost of owning long option positions.
Q: When should I use a credit spread?
A: Using this strategy traders will have a more versatile way to reduce their risk if the price of a stock moves against their expectations. However, the trader should be aware that it will reduce their profit potential.
Q: When should I use a debit spread?
A: This strategy will allow traders to plan their trade better. Using a debit spread can help the trader obtain a higher return when price changes fall in their favor.
Q: What is the difference between call debit spread and call credit spread?
Originally published: March 30, 2017, at 4:00 PM