Credit spreads and debit spreads are the strategies to trade-in options. In the title context, the spread is a difference between receipt and payment of the premium on writing/purchasing options. So, if the receipt is higher than payment on exchange of options, it’s called credit spread. On the other hand, if payment is higher than receipt is called a debit spread. For instance, if traders implement strategy and write options amounting to a premium of $20. Simultaneously, he buys options and pays a premium amounting to $15. So, the impact is receipt of the premium by $5 ($20-$15). Hence, it’s a net credit spread.
On the other hand, if trader implements options strategy and writes options for receipt amounting to $20 and pays premium amounting to $30. So, the net impact is the payment of $10 ($30-$20). Hence, it’s a net payment which is called the debit spread.
Detailed understanding
There are two types of spreads when we speak about investment in options. This type of spread depends on net receipt and net payment of the premium. If a trader pays a net premium, it’s called the debit spread. On the other hand, if a trader receives a net premium, it’s called credit spread. The net impact of payment and receipt is assessed when opening an investment position in the stock.
It’s important to note that investors need to enter into two options to form a spread. Further, the options’ strike price is different as an exchange of premium is different on entering the position. However, the underlying stock remains the same for both options.
Credit Spreads
The traders use credit spreads in line with the conservative strategy. It’s designed to earn modest profit and limit the loss on the position. Suppose if the options trader is bearish and expects the price of the underlying asset to fall in the future. He sets bearish call spread; it’s so-called because trader expected price of the underlying security to fall in the future. Furthermore, it makes use of the call options to open the position.
Following data relevant to the situation of traders,
Mr. Johan is a bearish trader and expects the price of an underlying asset to fall from the current price of $35. So, he opens the following position.
Issues/writes call options at strike price of $36 at a premium of 1.10 (1000 options and date of maturity is Jan-22).
Buys call options at a strike price of $37 at a premium of 0.75 (1000 options and date of maturity is Jan-22)
It’s a net credit spread because the total premium receipt is $1,100, which is more than the total premium payment, amounting to $750. Hence, it’s a net receipt and credit spread by $350.
So, if things remain in line with the expectation of Mr. Johan and the price of the underlying market remains below $36 till Jan-22, which is the date of expiry, the buyer of the 1000 options at $1.1 premium is not expected to realize his/her right. Hence, an amount of $1100 will be earned by Mr. Johann.
However, Mr. Johann has purchased options and will not exercise his right to purchase the security at $36 as the market price of the underlying security is under $36. Hence, there is a loss for Mr. Johann, amounting to $750. Hence, the total return for Mr. Johann amounts to $350 ($1100-$750).
It’s important to note that Mr. Johann is bearish and expected the market to remain static for the underlying security; his expectation proved valid and resulted in the maximum return generation amounting to $350, which is equal to credit spread.
Debit Spreads
Let’s understand debit spread with the help of an example. Suppose Mr. Johann opens the following position,
Sells 100 put options with a strike price of $10 and a premium of $1.
Buys 100 put options with a strike price of $20 and a premium of $5.
Since the total premium paid is $500 and the total premium received amounts to $100. So, the premium paid is greater by $400 ($500-$100). Hence, it’s a debit spread.
So, the potential loss of Mr. Johann is limited to $400. Mr. Johann has limited his loss by entering the position; otherwise, the loss potential amounts to $500 if the underlying asset’s price moves in an adverse direction (assuming no strategy implied).
Distinctive features of credit and debit spread
| Credit spread | Debit spread |
| If the trader gets cash on entering the position, it’s called credit spread. | If the trader pays cash on entering the positions, it’s called the debit spread. |
| Credit spread is a suitable investment strategy when a trader is unsure of the underlying asset’s directional movement. It may be move-in up/down direction. It’s about generating returns with low implied volatility. | A debit spread is a suitable investment strategy when traders expect a higher probability of an underlying asset’s price in a certain direction. |
| Return can be generated from this strategy while the underlying asset price remains the same or drops. So, the premium gap can be limited. | Return from this strategy is more when the premium gap is significant. The premium gap can be significant when parties in the contract are more intensive bearish and bullish, leading to agreement on a greater difference of strike price. |
| The response of strategy is slow. So, it takes significant time to realize a return for the trader. | The response is comparatively fast. |
| It’s a suitable approach to limit the loss. However, a trader needs to compromise on higher profitability. So, it’s a conservative strategy. | It also limits the loss. However, the extent is lower comparatively. |
| The trader gets a premium to open the position of credit strategy. So, if we consider the time value of money, it’s a form of income. | The traders need to deposit money to open the position of the debt strategy. So, If we consider the time value of money, it’s a form of expense. |
It’s important to note that both credit and debit spreads can be used for the bearish and bullish expectations of the trader. However, a trader needs to ensure their expectations are incorporated in the options’ opening position. For instance, if the trader is bearish, it should receive a higher premium for the downward flow of the underlying asset price.
On the other hand, if the trader is bullish, it should receive a higher premium for the upward flow of the underlying asset price. However, it’s in the case of the call options.
So, bullish and bearish behavior can be seen in the arrangement of opening positions for the options. It does not relate to whether the spread is credit or debit.
Conclusion
Options are financial derivatives that do not have innate value but drive their value from underlying assets/securities. The options give the buyer the right to buy or sell underlying assets. However, options are speculative and carry higher volatility in general.
So, some of the techniques have been introduced that limit the loss of the options. However, it leads to restrictions in the profit from an investment.
The implementation of the strategies includes receipt and payment of the premium. If more premium is received on strategy implementation, it is called credit spread. On the other hand, if more premium is a pain in implementing strategy, it’s called the debit spread.
Both debit and credit spreads can be used to satisfy the bearish bullish bets of the traders. The spread on the implementation of strategy arises from the simultaneous purchase and sale of the options for different strike prices and the same underlying assets.
Frequently asked questions?
What is the implied volatility of price?
The implied price volatility means the intensity of changes in the security’s price. It’s about the assessment of the price risk in the security. There is a higher risk and higher speculation if there is more volatility. Further, it’s useful in deciding if traders should opt for credit/debit spread. It’s because return generation on a debit spread is comparatively more directional.
Which strategy is better, credit or debit spread?
Both strategies are better. However, it’s about the use of strategy at the right time. For instance, if an option is expected to move in a certain direction, the direct spread can be a better strategy.
On the other hand, if the price movement is not directional, credit spread is used to generate a higher return.
What’s the difference between call and put options?
The call gives the right to purchase stock at an agreed price. On the other hand, put options give the right to sell stock at an agreed price.
What’s the main difference between credit and debit spread?
The main difference lies in the net receipt and payment of the premium. If a net premium is paid, its debit spread. On the other hand, if the net premium is received, its credit is spread.
Is credit spread bearish or bullish?
Both credit and debit strategies can be bearish and bullish. Bearish is when a trader benefits from stability/low movement in the price of an underlying asset. On the other hand, bullish is when trader benefits from increasing the price of the underlying asset. Whether the spread is bearish/bullish can be assessed by looking at the position of options. It’s dependent on the arrangement in the contract and the position of investing in the options.
