OAP 116: Debit Spreads Vs Credit Spreads – When To Use Each

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You've targeted a stock or ETF setup you like and want to make a directional trade. Maybe some technical indicator alerted you to a possible turn in the underlying or you just needed to hedge your portfolio with a new trade. Whatever the case, you are now left wondering why type of options strategy to pick. How do you decide between trading debit spreads vs. credit spreads and when should you use each style? In today's podcast, I'll walk through the different market environments and setups that might work best for each.

Key Points from Today's Show:

Debit Spreads

  • Debit spreads are directional options buying strategies where you are net paying for an options spread.
  • For example: 
    1. Buying a put debit spread would be a directionally bearish position -- buying a put option and then selling a put option at a lower strike price. 
    2. Buying a call debit spread, which is a directionally bullish position -- buying a call and then selling a call at a higher price. 
  • For most debit spreads, you want to enter during lower IV environments, generally. 
  • When entering a position where you are net buying options, you want to do so when implied volatility is super low - ex: IV rank of under 20.
  • When IV rank is very low and you enter a debit spread, one way to profit from that is if IV potentially increases.
  • With debit spreads, you are also more directional with your assumptions; stock will either turn around or continue in the same direction. 
  • The underlying foundation with debit spreads is that you want the stock to move.
  • Debit spreads can also be used for hedging purposes, because it offers quick exposure in one direction or another. 

Example: If you have several positions that are becoming too bearish and need some bullish exposure, you can buy a call debit spread, which effectively will give you exposure as soon as the market continues to move higher without experiencing lag time. You are generally buying these spreads around at the money strikes so as soon as the stock starts moving higher, you have immediate exposure towards that stock going higher. 

Credit Spreads

  • Credit spreads are a net selling strategy where you traditionally sell a spread out of the money. 
  • This gives you a high probability of success, but you are also potentially taking in a lower premium.
  • Ex: If the stock is trading at $100, you can sell the 105 call and buy the 110 call. 

Credit spreads are great in all environments:

  • Just because debit spreads work great in low IV environments, does not mean you should use them over credit spreads.
  • Even though IV can be low, that does not mean that the over-expectation of IV pricing, or IV edge, that you gain selling options disappears - it just gets reduced. 
  • So potential profit with expected returns is much smaller in low IV environments. 
  • Therefore, you can still trade credit spreads and sell options during low volatility markets you just want to scale back your position size. 
  • When IV is high, scale up and allocate more towards the trade. When IV is low, scale back the position size. 
  • Credit spreads are less directional in nature than debit spreads.
  • However, you can set up a credit spread to be bullish or bearish. 
  • But with a credit spread, you still have the potential to make money even if the stock stays the same or goes lower. 

Example: If the stock is trading at $100 and you sell the 95 put and buy the 90 put, the stock can stay at 100 and you make money. It can go down to 97 and you still make money. Or it can go up and you can make money. Therefore, it has less directional risk for an options trader as opposed to a debit spread. However, because you have less directional risk you take in less money. Ultimately credit spreads will pay more money, have lower draw downs, and higher expected returns.

  • Credit spreads are income-driven and react slower to the underlying market movements.
  • With credit spreads, since you are selling options and your income is capped, it's generally slower to react to the market movement because it's an out of the money option. 
  • Therefore, you do not necessarily realize the profits until much later in the expiration period. 
  • Where you end up choosing strike prices matters a lot in both credit and debit spreads -- based on time and IV levels. 

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
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Option Trader Q&A w/ Danny

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Danny, who asks:

When you sell a call, why do you need to buy another one below it?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.