When to Trade Credit or Debit Spreads

credit or debit

Credit or debit spreads are a great way to generate income and to limit your risk. The difference between credit and debit spreads, can be very important.

Let us first look what an Option Spread is. An option spread is when you buy and sell another option of the same type. It can be created with calls or puts options, always with the same underlying, in the same month but with different strikes.
What is the difference between a credit or debit spread? Well a debit spread would be a spread you pay money for. A credit spread would be a spread you receive money for.

 

How to select a Credit or Debit Spread

When is the best time to create credit spreads or debit spreads?  It all has to do with the option premium.  We like to sell option premium. Option Premium is influenced by Implied Volatility (IV).  When the implied volatility is high, you would typically create a credit spread. And at times when the IV is low you would like to create debit spreads.

 

 

Does risk in Credit Spread or Debit Spread differ

The amount of risk compared to potential reward in a credit trade is typically higher than the risk to reward ratio of the debit trade. So why would a trader pick a credit trade over a debit trade? The answer lies in probability and the number of trends optimized by the trades.

A debit trade almost always requires a trending equity. It can be bullish or it can be bearish but the equity needs to move. By contrast, a credit trade can be profitable in several trends.

Since the primary instrument in a credit trade is a short option, the passage of time in and of itself can take this trade to its maximum profit. The equity does not have to trend in order to be profitable. If the equity trends in the direction favorable to the short option the trade will be profitable and may offer the opportunity to close the trade early. So a credit trade typically can optimize three trends. That makes the probability of the trade going to a successful conclusion higher than that of the debit trade.

Debit trades optimize directional movement by the underlying equity. The risk in a debit trade is the amount of money the investor or trader has paid to initiate the position. The potential reward of the debit trade compared to its risk can be very high, however, directionality is almost always required for debit trade to be profitable.

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Conclusion

Trading Credit spreads and Debit spreads is an excellent low risk strategy. Choose your vertical spread depending on Volatility. The amount of reward is higher on a credit spread and you don’t have to be directionally right to realize a profit.