Understanding Debit and Credit Spreads

09/12/2011 3:30 pm EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

Credit and debit spreads are a great way to generate income and limit your risk, and Joe Kinahan reviews how to implement each of these strategies on any underlying equity.

There are a lot of different strategies you can use in options besides just buying and selling puts and calls.  One of those things is a debit or credit spread. 

We’re going to talk about that with Joe Kinahan here. Joe, first of all, what is a debit or credit spread?

Well a debit spread would be a spread you pay money for. A credit spread would be a spread you receive money for.

So, a couple quick examples: let’s talk about a debit spread first. It’s one I think people are probably more familiar with.

We’ll say that a stock—we’ll call it XYZ stock—is trading at $102. You think it’s going to go up. You may buy the $100 call and sell the $105 call. Its spread is worth $5 right now because it’s trading at $102; it’s worth at least $2, so you have $3 you can make to the upside if we continue to go up. 

If we go down, you can only lose the $2 you originally paid for it. If you’ll notice, in my example, I used a call that’s already in the money. Why, because it already does have some value. I’ve sold something that’s out of the money. When I buy something, I want to buy value and I want to sell junk, as they say. 

I buy a call in the money; sell one out of the money. 

If I was going to do a credit spread where I receive money, I would be more likely (stock is still trading at $102, we’ll say) to sell the $105 call (and) buy the $110 call.

There I’m selling two options that have zero value. It’s really about selling that $105 call. The only reason I bought the $110 call is because now I’ve defined my risk. I know that the spread can do no more than go to $5, and even if the stock went to $2000 tomorrow, that spread can’t be worth more than $5. 

People are so used to putting in stop orders, etc.; you don’t have to do that with credit spreads. You’ve already defined what your risk is up front. One of the keys, in my opinion, to being a successful trader is always defining what you can make and what you can lose before you make the trade. 

If you already know the worst-case scenario, it makes everything else a lot easier.

It sounds like that’s the real difference between a professional trader and a newer retail trader. They may just buy a call or buy a put or sell a put. 

A professional trader almost always hedges their position, so they’re going to take a little more sophistication with their options; does that sound about right?

That’s a really good assessment of it Tim. I always say that the difference between retail and professional, a retail trader often says “What can I make?” but a professional trader always says “What can I lose?”

Which one should I use if in both those cases I think the stock may be going up; is there a better one to use in certain situations?

No, there really isn’t. If I thought the stock was going up, I could do a debit call spread or I could do a credit put spread.

The one thing I would say is when you’re starting out, you might want to do your credit spread selling out of the money. That is the one thing I would definitely consider as a new trader.

Why is that most advantageous?

Because it gives you room to be wrong, more than anything else.

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