Investors with a foundational grasp of options may seek opportunities in more complex multi-leg options strategies. Debit and credit spread may be one such opportunity they consider.
Multi-leg strategies build upon the basics of single-leg strategies that consist of variations of long and short calls and puts, according to BMO. Debit and credit spreads fall under the vertical spreads category because they hold options with the same expiration date but differing strike prices. They are composed entirely of calls or puts only, though they will hold long and short positions of the option type used. Credit and debit spreads share certain similarities, and they allow investors to express a directional view of a security’s price while having defined risk and reward parameters. However, they differ in fundamental ways.
Credit Spreads
A credit spread entails selling an option with a high premium while also buying an option that’s further out-of-the-money and, therefore, cheaper. This generates net credit that translates to income for an investor. It’s a strategy that may be used both for income generation and to help mitigate risk.
The maximum return is the difference between the premium earned from the option sold and what is paid for the option bought. The maximum risk is the difference between the strike price span and the return potential.
For example, a bullish investor who believes stock XYZ’s prices will rise may create a credit spread using puts. If the stock is currently priced at $35.50, they might sell a put at a higher strike price of $35.00 and collect a premium of $0.65. At the same time, they purchase a put at a strike price of $34.00 for $0.32 with the same expiration date as the put sold.
The net credit of the put spread would be $0.33 ($0.65-$0.32). As options are sold in units of 100, the maximum return potential of the put credit spread would be $33, while the maximum risk is $67, given the strike price spread is $1.00.
Credit spreads benefit most when a stock’s price isn’t expected to make significant moves, but implied volatility is heightened. Higher implied volatility equates to higher premium prices, benefiting a credit spread. Although the risk/reward trade-off is elevated for a credit spread, it generally has a low break-even point and, therefore, may be profitable more often than a debit spread.
Debit Spreads
On the other hand, a debit spread includes buying an option at a high premium and selling an option with a cheaper premium. This results in the investor owing money overall for the spread.
The maximum risk is the difference between the premium paid for the option bought and the premium earned from the option sold. The maximum reward is the difference between the strike price spread minus the risk potential.
A bullish investor creating a debit spread using calls on stock XYZ, currently priced at $30, buys a call at $31.00 for $0.72 and sells a call at $33.00 for $0.21. The net debit of the call spread would be $0.51. In this scenario, the maximum risk potential is $51, while the maximum return potential is $149 (given the $2.00 strike spread).
While debit spreads appear to offer a more attractive risk/reward ratio, they often require a higher breakeven point compared to a credit spread. This means they generally have a lower probability of becoming profitable compared to a credit spread. This generally makes them more optimal to use in times when larger stock price movements are anticipated, which may include impending earnings announcements.
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