Debit Spreads and Credit Spreads Explained
When a trader buys and sells a combination of options, that trader is said to be putting on what is referred to in options trading jargon as a spread.
A debit spread is where the trader has to pay an upfront premium to enter into the trade. This is usually achieved by buying more expensive options and simultaneously selling cheaper options to partly offset the cost of the long options.
Debit spreads are popular with novice options traders for many reasons. One of them is the fact that they have a limited loss potential. The maximum loss for a debit spread is the net premium paid to enter the trade.
Debit spreads on the other hand also have a limited profit potential. This is because the short options start making a loss at some point, neutralizing the profit made from the long options.
Another reason why newbie traders like debit spreads is because they do not need margin to trade this type of spread. Since the maximum potential loss is equal to the net debit which the trader paid upfront, there is no need for the broker to charge margin on such a trade.
Debit spreads can be bullish, e.g. the well-known bull call spread. They can also be bearish, such as in the bear put spread.
There are also many non-directional debit spreads, including the popular butterfly spread and the reverse iron condor.
Credit spreads are entered into when the trader buys cheaper, usually further OTM, options and sells more expensive, usually closer to the money options. As the name implies the trader receives an upfront credit to his or her trading account for entering into such a trade.
Not all traders are allowed to do credit spreads. Some brokers require very large margin accounts before they will allow the trader to enter a credit spread.
The maximum profit of a credit spread is usually limited to the net credit received when entering the trade. Despite what many websites say about this, it is not always the case. There are credit spreads with unlimited profit potential. One example is the highly popular Call ratio backspread. The put ratio backspread is another one.
The maximum loss of a credit spread is usually limited. Apart form the lower margin requirements when compared to naked call or naked put writing this is one of the biggest reasons why traders find credit spreads attractive.
As with debit spreads, there is a credit spread available for virtually every type of market. In a bullish market, traders have the bull put spread and when they are bearish the bear call is at their disposal.
Traders who expect the market to remain trading in a narrow range can enter into a short butterfly or a short condor trade, while in a volatile market the same traders could make use of the very popular iron condor or iron butterfly.
Both debit spreads and credit spreads have their ardent followers. The truth is, however, that for every debit spread there is a credit spread that will very much fulfil the same purpose and vice versa. There are exceptions to this rule, however, such as in the case of the call ratio backspread mentioned earlier, which means there are sometimes situations where one or the other will do a better job than its counterpart.