How Are Credit Spreads Different from Debit Spreads?

10/29/2009 12:01 am EST


In this article, we will examine a specific case of a debit and a credit spread in order to point out that there is very little difference between the two. To explain the concept, I'll utilize actual trades that I made at the end of 2008.

My normal criteria for trading "optionable" stocks is the liquidity, which is evident in the volume of the underlying, as well as the high open interest and volume on individual strike prices. At the time of these trades, Chevron Corp. (CVX) passed those minimum requirements.

After knowing what to trade, the issue becomes when to trade it. The chart below shows that on December 4, 2008, CVX was trading slightly above $70, which in the past had acted as a short-term diagonal support.

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Strategy Selection

After completing my technical analysis and determining my market posture, as well as my directional bias on the stock, I am faced with the strategy selection. According to my rules, I go long at the support. The CVX was not exactly at the support, but it was very close to it.

Timing the entries perfectly is nearly impossible; it is the timing of the exits that is of more essence to me.

While Chevron was at or near its support, I had numerous choices for going long:

1. Buy the underlying
2. Buy a call
3. Buy a debit spread, namely a bull call
4. Sell a credit spread, explicitly a bull put

I worked out the numbers of risk to reward, and they came out very much identical for both the credit and debit spread. My bull put had a return on investment (ROI) of 37%, while my bull call was 36%. Not even once did I consider going long with a straight directional call.

The Bull Call Explanation

By choosing a bull call instead of a directional (non-spread) straight call, I have reduced two things: My exposure and my financial outlay.

However, let us get to the particulars. Had I just purchased a call, I would have paid $9.52 for a CVX Dec 65 call, which would have been $952 for one contract plus the commission.

Instead, I simultaneously bought Dec 65 calls at $9.52 and sold the Dec 70 calls for $5.82, which, in turn, reduced my entry price to $3.70, or $370 per contract, plus the two entry commissions.

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As the figure above shows, I did this transaction twice and got an even better fill of $3.65 on the second transaction.

Let us combine these two bull calls:

Bull Call Example

I bought to open (BTO) two contracts of Dec 65 calls at $9.45 (average fill) and sold to open (STO) two contracts of Dec 70 calls at $5.775 (average fill). My maximum loss was the difference between the premium, which is a debit of $3.675 or $367.50 times two contracts. My maximum profit is the width of spread (strike price 70 minus 65 strike) subtracted from the debit.

Specifically, $5 - $3.675 = $1.325. Therefore, the most I could have made on this trade would have been $132.50 times two contracts. From this amount, the two exiting commissions need to be subtracted. To calculate the ROI, we need to divide our max profit of $1.325 with our debit of $3.675, which gives us 36% as our ROI for the bull call spread.

NEXT: Exploring the Credit Side of This Trade


The Bull Put Explanation

Having explained the debit part of the trade, we could turn our attention to the credit part of it. The figure below shows an additional trade, which is in red because it was a sold for the credit.

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On the bull put, I had BTO Dec 65 puts at $1.52, and simultaneously, STO Dec 70 puts at $2.87, receiving the credit in the difference of those two premiums ($2.87 - $1.52 = $1.35), which is $135 for one contract. Once again, the spread's width of $5 - $1.35 (our max profit) would give us $3.65 as our max loss. The ROI is $1.35 (max profit) divided by $3.65 (max loss), which comes to 37%. In short, the ROI on the bull put is only 1% better than bull call's ROI of 36%.

A brief note: The max profit of $1.325 per contract on the first vertical (bull call) and the max profit of $1.35 on the second vertical (bull put) are just that, the max profit. The max profits are occasionally achieved if the trader holds the position until the expiry. In my case, the chart determined my exit.

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The figure above shows that on December 8, 2008, CVX had approached the $80 area, which in the past has acted as a support. On that day, the old support had acted as a new resistance.

Observe on the chart that CVX traveled almost ten points within four trading sessions. Both of my vertical trades were bullish trades, and the chart was telling me that it was unable to break the resistance. So, on December 9, 2008, I closed both of my verticals.

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The figure above shows that I closed both of the debit spreads for $4.30 each. To recap, I got in at $3.65 and sold it for $4.30, making the difference on the two, which was 62.5 cents per contract. I had two contracts, thus the profit was $125; whereas I sold the bull put at the high price of $1.35 and bought it back at 65 cents, making a 70-cent profit, or $70 for the contract.

In both cases, I made about half of the maximum profit I may have made if I held it until December 19, 2008, which was the day of expiry.

Just ask yourself: Does it make more sense to close the position that has achieved half of its initial goal in four trading sessions, or hold it, risking what is already made?

In my case, the answer was obvious.

In conclusion, in this article, I have compared apples with apples. Both the credit and debit spread had four commissions -two for entry and two for exits. In some cases, the credit spread might not have the exiting commissions, yet in this case, I have selected the trades of the same number of commission on the very same underlying.

In short, when zooming in on the specifics, there is very little difference between the credit and debit spreads. In both cases, I was the seller of the premium, which very much goes along with my belief that one should be trading options with the well-defined risk, rather than trading them directionally without any spread strategy.

By Josip Causic of Online Trading Academy

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