Credit Spread vs. Debit Spread: An Overview
When trading or investing in options, there are several option spread strategies that one could employ鈥攁 spread being the purchase and sale of different options on the same underlying as a package.
While we can classify spreads in various ways, one common dimension is to ask whether or not the strategy is a credit spread or a debit spread. Credit spreads, or net credit spreads, are spread strategies that involve net receipts of premiums, whereas debit spreads involve net payments of premiums.
- An options spread is a strategy that involves the simultaneous buying and selling of options on the same underlying asset.
- A credit spread involves selling a high-premium option while purchasing a low-premium option in the same class or of the same security, resulting in a credit to the trader's account.
- A debit spread involves purchasing a high-premium option while selling a low-premium option in the same class or of the same security, resulting in a debit from the trader's account.
A credit spread involves selling, or writing, a high-premium option and simultaneously buying a lower premium option. The premium received from the written option is greater than the premium paid for the long option, resulting in a premium credited into the trader or investor's account when the position is opened. When traders or investors use a credit spread strategy, the maximum profit they receive is the net premium. The credit spread results in a profit when the options' spreads narrow.
For example, a trader implements a credit spread strategy by writing one March call option with a strike price of $30 for $3 and simultaneously buying one March call option at $40 for $1. Since the usual multiplier on an equity option is 100, the net premium received is $200 for the trade. Furthermore, the trader will profit if the spread strategy narrows.
A bearish trader expects stock prices to decrease, and, therefore, buys call options (long call) at a certain strike price and sells (short call) the same number of call options within the same class and with the same expiration at a lower strike price. In contrast, bullish traders expect stock prices to rise, and therefore, buy call options at a certain strike price and sell the same number of call options within the same class and with the same expiration at a higher strike price.
Conversely, a debit spread鈥攎ost often used by beginners to options strategies鈥攊nvolves buying an option with a higher premium and simultaneously selling an option with a lower premium, where the premium paid for the long option of the spread is more than the premium received from the written option.
Unlike a credit spread, a debit spread results in a premium debited, or paid, from the trader's or investor's account when the position is opened. Debit spreads are primarily used to offset the costs associated with owning long options positions.
For example, a trader buys one May put option with a strike price of $20 for $5 and simultaneously sells one May put option with a strike price of $10 for $1. Therefore, he paid $4, or $400 for the trade. If the trade is out of the money, his max loss is reduced to $400, as opposed to $500 if he only bought the put option.