Credit Spread or Debit Spread: Which Options Trading Strategy is Best for You?

Sep 12th, 2013 | By | Category: General Comments
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Is there a difference between a credit spread and a debit spread?

Of course you might answer that you receive a credit for the credit spread and pay a debit for the debit spread, right? Well, you might come to find out that it is never as simple as one might think with options. Let’s take a look at an example.

Stock XYZ is trading for $100. You decide to sell a bearish call credit spread otherwise known as a vertical spread for $1 for the strikes 105/110. Let’s say the price for the 105 call is $3.50 and the 110 call is priced at $2.50. Since you are selling the more expensive option you receive a $1 credit to your account. However, there is a $5 risk or $500 per spread so your broker will make sure that  you have at least $500 set aside in case of a loss—this is know as your “gross margin”.

So your potential reward in this trade is $100 and you are risking $400 ($500 gross margin minus the $100 you initially received). If you hold the position until expiration you are hoping that your spread which was sold for $1, will expire for $0 and you keep the $100 you sold it for.

Now, let’s take a look at a debit spread. Using the same example where stock XYZ is trading for 100 you decided to buy a bearish put debit spread at the same strikes. In this case you again purchase the 110 strike and sell the 105 strike. But since these puts are both “in the money”, the 110 put will cost more than the 105 put. Let’s say you purchase the 110 put for $9.50 and sell the 105 for $5.50, for a total cost of = $4.00.

Your broker will make sure you have the $400 in your account to pay for the cost of the spread when you open the trade. Performing the same analysis as above for the credit spread, the risk in the trade is $400 (the amount you paid—thus, the most you can lose) and the reward in the trade is $100 if the spread goes to its full value of $5, which will happen as long the stock closes, at expiration, below $105.

So you end up making $100 with a risk of $400! This is exactly the same as our credit spread example above! That’s one of the reasons they say “a put is a call and a call is a put”. If you buy and sell the same strikes, whether put or call, you should theoretically end up with the same outcome in the case of a vertical spread as discussed.

We also like to say that these are “synthetically” identical positions. You can put on the exact same trade economically using either puts or calls. Now there might be some advantages to using one over the other such as the bid/ask spreads being tighter in the calls versus the puts in the above example or differences in open interest or volume between the puts and calls in particular cases, but let’s not confuse the issue at this point.

In the end though, there is no theoretical difference between a credit spread and a debit spread at the same strikes of the same expiration period. It always comes down to the risk versus reward of the trade and how much margin is set aside by your broker in the case of credit spreads or how much you pay for the spread in the case of debit spreads that counts.

Seth Freudberg and Michael Schwartz

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