Credit Spreads or Debit Spreads? Actually, You Should Be Using Both. Here's Why. (Part 2)

In part 1 of this lesson we took a look at what debit spreads were, and how they work. The explanation, however, is only the first piece of the groundwork we're laying to illustrate how and why you'd want to use them but also use their opposing trade... the credit spread.

As a refresher, a debit spread means you're a net-buyer of options by buying an option in anticipation of a move from a stock or index, but offsetting the cost of buying that option by selling a slightly less expensive option of the same type on the same stock. This sort of trade is limited in its upside, but also limits your net downside risk.

A credit spread works differently. In fact, it works exactly the opposite of a debit spread. From the beginning....

A debit spread is an options trading strategy where you simultaneously buy and sell options on the same underlying security with the intention of limiting your upfront cost (debit) while also defining your maximum potential loss and gain. It's called a "debit" spread because you pay to enter the trade, resulting in a net debit to your account. Unlike a credit spread, the "bet" with a debit spread is that the underlying stock or index won't change much in price, or will even reverse its current direction. Debit spreads are also ideally allowed to expire without executing a counter-trade to close it out, just to sidestep another trade commission. A successful debit spread, however, can still be profitably closed out with counter-trades (buying back the shorted option, and selling the long option).

There are two main types of debit spreads: the bull call spread and the bear put spread.

Bull Call Spread

A bull call spread is used when you expect the price of the underlying asset to rise moderately. It involves buying a call option with a lower strike price and simultaneously selling a call option with a higher strike price. The idea is to participate in the potential upside while offsetting some of the cost by selling the higher strike call.

Example? Let's assume stock XYZ is trading at $100 per share, and you are bullish on its short-term outlook. You execute the following bull call spread:

• Buy a call option with a strike price of $95 for a premium of $6.
• Sell a call option with a strike price of $105 for a premium of $3.
• The net premium paid (debit) for this trade would be $6 (cost of the bought option) - $3 (credit from the sold option) = $3.

The payoff scenarios at expiration are....

• If XYZ's price is below $95 at expiration, both options expire worthless, and you lose the entire $3 premium.
• If XYZ's price is between $95 and $105, the lower strike call option will be in-the-money and offset the loss on the sold call option, resulting in a partial loss.
• If XYZ's price is above $105, both options will be in-the-money, and the gains on the lower strike call will outweigh the loss on the sold call, resulting in a maximum profit of $105 - $95 - $3 (net premium) = $7 per share.

Bear Put Spread

As for bear put spreads, this option-trading strategy is employed when you expect the price of the underlying asset to decline moderately. It involves buying a put option with a higher strike price and simultaneously selling a put option with a lower strike price. This strategy helps mitigate the cost of buying the higher strike put.

As for an example, let's use stock ABC, which is trading at $50 per share, and you have a bearish short-term outlook. You implement the following bear put spread:

• Buy a put option with a strike price of $55 for a premium of $4
• Sell a put option with a strike price of $45 for a premium of $2.
• The net premium paid (debit) for this trade would be $4 (cost of the bought option) - $2 (credit from the sold option) = $2.

Your possible scenarios at expiration are...

• If ABC's price is above $55 at expiration, both options expire worthless, and you lose the entire $2 premium.
• If ABC's price is between $55 and $45, the higher strike put option will be out-of-the-money and offset the loss on the sold put option, resulting in a partial loss.
• If ABC's price is below $45, both options will be in-the-money, and the gains on the higher strike put will outweigh the loss on the sold put, resulting in a maximum profit of $55 - $45 - $2 (net premium) = $8 per share.

Great, but which kind of trade is better? Neither is "better" or "worse." The two opposing types of option spread trades simply have their own strengths and weaknesses depending on the situation and backdrop. We'll look at these strengths and weaknesses in part 3 of this lesson. Stay tuned.