Give Me Some Credit!
Why Credit Spreads are Debit Spreads in Disguise
By Bill Johnson
Everybody likes credits. We want credit for the work we do. We get credits for taking college classes. And, of course, we love our credit cards.
It only makes sense that when using vertical spreads, we should love the credit spread over the debit spread. A credit spread is simply the seller to the trader who bought the spread. The buyer pays a debit. The seller gets the credit. Well, you don’t need to know anything about options to figure out that the credit side is better, right?
Actually, you do need to not know anything about options to believe it’s true.
There’s always a debate among traders over debit and credit spreads, so let’s be sure you understand the art and science behind these two sides of the same trade.
As a refresher, a vertical spread is the purchase of one option and the simultaneous sale of another. Both must be the same type (calls or puts) and have the same expiration date. For instance, if you buy a Facebook May $160/$165 call spread, you’re buying the $160 call and selling the $165 call. Because lower strike calls must be worth more money for any expiration, this is a debit trade.
The most you can make from the trade is the difference in strikes, or $5 for this example. That’s because you have the right to buy shares at $160 and the potential obligations to sell them for $165. If you paid $3 for the spread, the most you can make is $2. As a check, the amount paid added to the maximum loss must equal the difference in strikes, or $3 + $2 = $5 difference in this example. By entering a spread, you have limited risk and limited reward:
However, you can get the identical risk profile by selling the same put spread – same strikes and expiration. If you sold the $160/$165 put spread, you’d have the same risk graph. And yes, it will be bullish too. It will be identical to the call debit spread. However, because you’re the seller, you’d receive a credit. And it’s at this point that most traders immediately jump to the conclusion that the credit trade must be better. After all, everybody loves credits.
Buyers Have Rights. Sellers Have Obligations
However, when you buy a spread, you have rights. You own something that might appreciate. But when you sell a spread, you have an obligation equal to the difference in strikes. You can think of debit spreads as assets and credit spreads as liabilities. Part of the misperception with credit spreads is that traders think they’re earning a credit to take on an asset. They’re not. They’re getting paid to accept a liability.
For example, by selling the $160/$165 put spread, you’re long the $160 put and short the $165 put. For puts, higher strikes are worth more money, as you have the right to sell shares for more money. Therefore, to receive a credit from this position, you must be selling the $165 put – that’s what’s providing the overall credit.
Now check your rights and obligations: If you sell the $165 put, you have the potential obligation to buy shares for $165. By purchasing the $160 put, you have the right to sell shares for $160. Buying shares at $165 and selling them at $160 is a five-dollar loss. There’s no asset anywhere in the equation. It’s a five-dollar liability. That’s why you’re getting paid to accept the trade. Spread sellers act like an insurance company. They’re collecting a smaller amount today, say $2, to insure a larger loss, say the $5 difference in strikes.
Here’s the important relationship you must understand to find which spread – the debit or credit – may be most effective: Buying the call spread is identical to selling the put spread. How is that possible?
Go back to the original $160/$165 call spread trading for $3. That’s an opportunity to pay $3 and potentially make $2. However, the if it’s trading for $3, the $160/$165 put spread must be selling for $2. By selling the spread for $2 that’s the most you can make, but you may lose $3. Wait a minute, that’s exactly the same as the call spread!
Exactly right. There is no difference.
To take it a step further, if you buy the call spread, your broker will debit your account $3, or $300 total, to buy the call spread since that’s the most you can lose. However, if you sell the put spread for $2, the broker will still debit your account for $3 since, again, it’s the maximum you can lose. Brokers don’t care how much you can make. They do care about how much you can lose, so the margin requirements are always pegged to the maximum loss. No matter how you cut it, a debit spread is a credit spread. There’s no reason to automatically prefer one over the other. Why bother learning both?
In the real world, you’ll get slight pricing discrepancies due to put-call skews. For instance, if you can buy the call spread for $3, you may be able to sell the put spread for $2.20. In that case, you’re better off with the put spread. You can make more ($2.20) and lose less ($2.80).
But many times, skews work the other way. If the call debit spread is trading for $3, the corresponding put spread may be selling for $1.80. Now you’re better off buying the call spread – even though it’s a debit trade.
Options trading is the most rewarding, but it’s even more rewarding when you understand the finer points – the art and science of options trading. Now that you understand, give yourself some credit.
Good Investing!
Bill Johnson, Steve Bigalow
and The Candlestick Forum Team
P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.
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