Credit Spreads or Debit Spreads? Actually, You Should Be Using Both. Here's Why. (Part 1)

If you're ready to move beyond the mere purchase of put or call options, great! You'll be opening up a whole new world of ways to take advantage of how option prices change. As you may likely already know, it's not so simple. There are a lot of factors that influence -- often unexpectedly -- option pricing.

And, perhaps one of the next-best-ways tools to add to your options trading toolkit is the use of credit spreads and/or debit spreads. But, which one should you try to navigate first? Both, actually. See, there are times it makes more sense to be a net-seller (credit spreads), but other times it makes more sense to be a net-buyer (debit spreads).

But first things first... what's a credit spread, and for that matter, what's a debit spread?

A debit spread is an options trading strategy that involves simultaneously buying and selling options of the same underlying asset but with different strike prices and/or expiration dates. The goal of a debit spread is to limit the initial investment (debit) required while still potentially benefiting from price movements in the underlying asset. More to the point, with debit spreads, you still ultimately want the underlying stock or index to make a move in a predicted direction, as that will ensure your best profit scenario is achieved. Although you're trade is hedged with a short position of the same option type on the same stock or index, that short position is only defrays the cost of  "being long." It also just happens to limit your net upside. But, that's ok. Risk-management is the key and goal here.

There are two main types of debit spreads: Bull call spreads and bear put spreads.

As you might have guessed, a bull call spread is used when an investor expects the price of the underlying asset to rise moderately. It involves buying a call option (long call) with a lower strike price and simultaneously selling a call option (short call) with a higher strike price. The long call provides upside potential, while the short call generates income and helps offset the cost of the long call.

As for bear put spreads, this strategy is used when an investor expects the price of the underlying asset to decrease moderately. It involves buying a put option (long put) with a higher strike price and simultaneously selling a put option (short put) with a lower strike price. The long put provides downside protection, while the short put generates income and offsets part of the cost of the long put.

The maximum profit for a bull call spread is limited and occurs when the underlying asset's price is above the higher strike price at expiration. The maximum loss is limited to the initial debit paid to establish the spread.

Conversely, the maximum profit for a bear put spread is limited and occurs when the underlying asset's price is below the lower strike price at expiration. The maximum loss is limited to the initial debit paid to establish the spread.

Let's look at one example... a bull call spread.

Suppose you are bullish on Company XYZ's stock, which is currently trading at $50 per share. You believe that the stock will increase in price over the next few weeks, but you also want to limit your potential losses in case the stock doesn't perform as expected. To set up a bull call spread, you would follow these steps:

• Buy a call option with a lower strike price (in-the-money call option) to benefit from the stock's potential upside.
• Sell a call option with a higher strike price (out-of-the-money call option) to generate income and partially offset the cost of the first option.

Let's say you choose to buy the XYZ $45 call option (with a strike price of $45) and sell the XYZ $55 call option (with a strike price of $55). Both options have the same expiration date, which is two months from now. Assume the $45 call option costs $7 per contract, and the $55 call option is selling for $2 per contract. The debit (your net cost) equals the premium of $45 call minus the premium of the $55 call. That's $7 minus $2, or $5 per contract.

There are only three categories of potential outcomes here:

• 1. The stock price goes above $55.

In this scenario, the $45 call option (the long call) will be in the money and have intrinsic value. The $55 call option (the short call) will also be in the money but will have a higher strike price, so its value will be lower. The maximum profit is limited to the difference between the strike prices ($55 - $45 = $10) minus the initial cost of the spread ($5). In this case, the maximum profit would be $5 per contract.

• 2. The stock price remains between $45 and $55.

Both the $45 and $55 call options will expire worthless (out of the money), and you'll lose the initial cost of the spread ($5 per contract). The maximum loss is limited to the initial cost of the spread.

• 3. The stock price falls below $45.

The $45 call option will expire worthless (out of the money), and you'll lose the premium paid for it ($7 per contract). The $55 call option will also expire worthless (out of the money), but you initially received a premium for selling it ($2 per contract), reducing the overall loss. The maximum loss is limited to the initial cost of the spread ($5 per contract).

But you're bearish? Reverse everything in the example above, and substitute the puts for calls. You should be paying to take on the trade because the put you're buying will cost more than the put you're selling -- since the one you're buying is deeper in the money or at least closer to being deeper in the money -- than the put you're selling.

Stay tuned for part 2 of this article, which will explain how credit spreads differ from the debit spreads described above. You'll need this understanding to fully understand (and appreciate) why you should be willing and able to make both kinds of option trades.