Are you wondering which is better: option trades that result in a credit or trades that result in a debit? Simply put, you’re asking whether you should choose a credit spread or debit spread strategy. Let’s consider both options in more detail.
A credit spread (also called a net credit spread) involves the investor selling one option then buying another option. The second option is in the same class and also shares the same expiry date. However, there are different strike prices between the two options. In this instance, the new investor gets a net credit for entering this position. He is looking forward to the spreads either narrowing or expiring in order to get a profit. A credit spread is basically a conservative strategy in investment. It is designed to earn a moderate level of income while also limiting your potential loss. In this circumstance, you are buying and selling options on the same index in the same month. Remember, the only thing different is the strike price. The most common credit spreads are the Bull Put Spread and the Bear Call Spread.
What about debit spreads? First of all, investors have to pay to enter a debit spread (or net debit spread). This option is when the investor buys an option with a higher premium but must sell the option for a lower premium. How will this bring profit? Because the investor is hoping that the premium of his two options will widen due to the market.
Another issue to consider is that of what type of strategy you are going for with credit or debit spreads; as in bull or bear? The bull or bear strategy involves doing what you’re doing—selecting selling two options, but choosing both call or put options, and with the same expiration dates. (The strike prices can be different) The basic philosophy of bullish in stocks is that you buy low and sell high, which can be called an optimistic outlook, or bearish, buy high and sell low, which is a pessimistic approach. Both of these may work with any given strategy.
When you bring credit/debit into the equation, there are more issues to resolve. First know that with a credit spread, the required margin will be the same as the difference between both strike prices. This is the most you can lose. Your capital requirement will be reduced since you can apply the credit of premium to the margin. Now let’s consider debit spreads on the opposite end of the spectrum. These are called debit spreads because your broker is actually going to debit your account for the net premium, as opposed to giving you credit. The most you lose with the debit spread is the premium net. Gains are limited and this option does not require a margin.
In deciding which works better for you consider the time value involved. If you know a stock or underlying is going to move in a certain direction and you know to what price a debit spread can result in more profit. On the other hand, if all you know is a stock is going to move in one direction or not much, than you can place your trade in the other direction.
Let’s look at an example. If you use technical analysis, you can determine support and resistance lines, as well as trendlines. Say a stock is trending up and has support at $50 and is trading at $54.39 right now.
You feel the stock is going to go higher but you do not know by when. Your best bet is to sell a 50/45 Put spread. You sell the 50 put and buy the 45 put in the same month. For the sake of the example, you will trade the current month with the fewest days to expiration. As long as this stock stays above $50 you make the full amount of the credit.
If you think the stock is going to go to $60 in 2 weeks, you can use a debit spread. You would buy the 55 call and sell the 60 call in the same month. You would get the max profit if the stock is above $60 at expiration. But if the stock does not move up, your options will lose value everyday and eventually expire worthless.
With a credit spread, if the stock does not move, you still make money.
Basically we are talking about two sides of the same coin. A debit spread for one trader is a credit spread for another.