Credit Spreads or Debit Spreads? Actually, You Should Be Using Both. Here's Why. (Part 3)

In part 1 one of this lesson we looked at debit spreads, how they work, and why you'd want to use them. In simplest terms, a debit spread is still a net-long purchase of a put or call that bets on a stock's (or index's) direction. In that it's a debit, you're paying money to own the position with plans to close it out at a higher exit price later.

In part 2 of this lesson we explored credit spread. These are net-short positions, meaning you're selling a put or a call with plans to buy it back later at a lower price. This still requires the underlying stock or index to move in a certain direction to be profitable (or at least not move in the wrong direction). You're still buying a put or a call to hedge the bet, but you're selling or shorting a more expensive option. That's the "credit."

But which type of trade do you want to use? It depends on the circumstances and market backdrop. More specifically, it depends on the underlying stock or index's volatility at the time of the trade.

See, since volatility increases the prices of options (at least temporarily), that's when you'd want to be a net seller of options. That's what a credit spread does. If volatility is relatively low and therefore option premiums are subdued, it often makes more sense to be a net buyer of options, with debit spreads. In fact, some spread traders often refer to these ideas as "selling volatility" or "buying low volatility."

The ultimate goal in both instances, however, is to gain an edge with your particular spread trade by capitalizing in changes to a stock's (or index's) volatility that benefit you.

Surprised? Maybe a little confused? Let's look at everything one small piece at a time, as there's a bit more to the matter than upward or downward pricing pressure on a stock's or index's options.

Debit spread trades are generally more advantageous when volatility is relatively low because....

1. Lower option prices: Remember, debit spreads involve buying one option and selling another. When volatility is low, option prices are cheaper, including both the option you buy and the option you sell. This means that the overall cost or debit required to establish the spread position will be lower, making it more cost-effective for you as a trader.
2. Reduced impact of time decay: Options tend to lose value over time due to time decay (theta decay). When volatility is low, the rate of time decay is typically slower, which means the value of both the bought and sold options in the debit spread erodes more gradually. This is beneficial for debit spread traders since they are net buyers of options and want to minimize the impact of time decay.
3. Favorable spread width: In debit spreads like the bull call spread and bear put spread, the difference in strike prices (i.e., the spread width) impacts potential profits. When volatility is low, the spread width might be narrower, which means the breakeven points are closer to the current stock price. This can increase the probability of the trade reaching a profitable outcome.

The exact opposite applies to credit spread trades. These trades are better suited for times when a stock's or index's volatility is unusually high because...

1. Higher option premiums: Again, credit spreads involve selling one option and buying another. When volatility is high, option prices tend to be more expensive, including both the option you sell and the option you buy. This means that you can receive a larger credit when selling the spread, which reduces your overall risk in the trade.
2. More attractive range for the spread: In credit spreads like the bear call spread and bull put spread, the difference in strike prices (i.e., the spread width) impacts the probability of success. When volatility is high, the spread width tends to be wider, which means you can create a spread with a larger range between the sold and bought options. This wider range allows the underlying asset more room to move while still remaining within your chosen range.
3. Favorable impact of time decay: Credit spreads benefit from time decay (theta decay) because, as time passes, the options you sold lose value. When volatility is high, the rate of time decay is typically faster, accelerating the erosion of the sold option's premium.

As for figuring out if volatility is high or low at a specific point in time, you can often just eyeball it, or sense it. If you're a true numbers person though, many market-data services and brokers can provide the historical volatility levels for any type of trading instrument. A handful of them can even tell you the so-called implied volatility of a stock or index based on option prices at the time.

The goal is the same though. You want to sell big option premiums when they're pumped up due to high volatility, and you want to be a net buyer of low-priced options when volatility is low, but could be on the verge of ramping up. The difference may only mean pennies in the end, but with spreads, every penny matters.

Pro tip: If you really want to add some sophistication to your credit or debit spread trade selection, consider the option Greek vega. This is the Greek that tells you how sensitive an option's price is to changes in the volatility of an underlying asset. Namely, it shows you how much an option price changes for every 1% worth of change to implied volatility.

The specifics to the pro tip: You typically want to buy low volatility -- enter debit spreads -- when the vega figure on the long piece of the spread trade is low but vega is positive. If volatility rises after you enter the trade, the value of your trade improves because the positive vega says increasing volatility will boost your options' value. On the flipside, you'd ideally sell volatility when volatility is high and the vega on your trade is net-negative (or at least net negative on the more expensive option in your credit spread.) A decline in implied volatility would work in your favor in this scenario.

Still confused? As always try several of these trades "on paper" first until you understand their nuances. It will all make much more sense when you're seeing them unfold in real life.