Spread-Trading: 3 Tips to Remember

09/20/2013 8:00 am EST

Focus: OPTIONS

In this article, we will discuss when you might want to use a debit spread over a credit spread or vice versa, note Seth Freudberg and Michael Schwartz of SMB Capital.

There really isn’t a meaningful economic difference between a credit and debit spread on different sides at the same strikes. It just comes down to the risk in the trade, as that is the minimum that your broker will use for margin in the trade in the case of a credit spread, or the cost of the spread in the case of a debit spread. But is there a way that we can use this knowledge to help improve our trading?

Let’s say you were attempting to fill a bearish spread, with five-point strike separation, and you were indifferent as to whether it is accomplished as a credit spread or a debit spread, you could put in two orders—a call credit spread and a put debit spread for the same strikes. You would then use an OCO or “one cancels other” order (assuming your broker offers such orders) when placing this trade and put the two trades in at economically equivalent prices. So if the call spread was selling for $.50 you could place a sell order for the call spread at .50 and a buy order for the put debit spread at $4.50. Once one of the two orders is filled, the other will be canceled immediately. So it gives you two chances of getting filled.

Another situation where you might think of using this knowledge is the following. Say you have an account less than $25,000. In that case your broker will restrict you to what they identify as three options “day trades” per week. This is important to understand because if your account does get restricted, you would not be able to adjust a trade by closing or modifying a position on the same day that it was opened. So, even though you don’t consider yourself an options day trader, you might find a situation where you opened a trade and had to adjust it in the same day by closing the spread and moving it to different strikes. The brokers don’t know or care that you had to adjust your position, they just see this as a day trade so now you only have two day trades left that week.

Now let’s say that you sell an out-of-the-money put spread and get filled, only to realize that you accidentally bought the spread instead of selling it. You might find this funny and not probable, but order execution mistakes do happen. Now you find that you need to correct this immediately by reversing the trade and then selling it like you originally planned. The problem is that this would count as your second-day trade of the week and now you are close to being at three day trades that week!

Is there something we can do with our knowledge of equivalent spreads to help us out of this dilemma? The good news is that there is in fact something that we can do. Normally, we would simply reverse the trade by selling the put spread, but to avoid this day trading issue, instead, we could buy the call debit spread at the same strikes. If the put spread you bought instead of sold cost you $50, you would then want to buy the call debit spread for no more than $450.That would flatten the trade out and eliminate any risk aside from the differences in prices you paid between the two spreads. Then the next day you could close out both positions and reassess the situation.

There is a downside to this approach in that your call debit spread will cost you commissions and tie up twice the trading capital for the day. Now you have $900 tied up in the trade (the net margin on the credit spread plus the cost of the debit spread). But since it is only one day, it might not be much of an issue. It is always a good idea to know your options (pun intended) or choices when you are trading.

By Seth Freudberg and Michael Schwartz of SMB Capital

Related Articles on OPTIONS