Credit spreads and debit spreads are option strategies classified as vertical spreads. Vertical spreads are multi-leg, defined risk options strategies with two different strike prices sharing the same expiration date. They are called vertical spreads because the strikes are listed vertically on an options chain:
A credit spread is an options strategy that involves selling one option and buying another option further out-of-the-money for a net credit. It is called a credit spread because you collect the premium when entering the trade. Credit spreads can be used to generate income leveraging probabilities and defined risk.
A credit spread’s initial premium received is the maximum potential profit for the trade. The credit minus the spread’s width (that is, the difference between the two options) is the maximum potential loss. For example, if you sell a 50C and buy a 55C to collect $1.00, your max profit potential is $100 and your max loss potential is -$400 if both options are in-the-money at expiration.
The break-even point is the credit amount above (call spreads) or below (put spreads) the position's short option strike price. Learn how to calculate break-even prices for any options strategy with podcast episode 219: How to Calculate Break Even Prices for Option Strategies.
A debit spread involves buying one option and selling another option further from the underlying stock. The trade is opened for a net debit, meaning you'll pay the premium when opening the position. Like credit spreads, debit spreads can be used to express a directional bias with defined risk. Profit potential is also capped.
The initial debit paid is the maximum potential loss, while the maximum potential profit is the spread’s width minus the debit paid. So, if you buy a 50C and sell a 55C and pay $2.00, your max potential loss is -$200 and the max profit is $300 if both options are in-the-money at expiration. The break-even point is the debit paid above (call spreads) or below (put spreads) the position's long option strike price.
Advantages & disadvantages of vertical spreads
Vertical spreads are a great options strategy for experienced and beginner traders because they are defined risk positions with varying degrees of directional bias. Potential profit is limited, but spreads typically require less capital at entry than buying stock or even single-leg call and put options.
Credit spreads and debit spreads offer investors a lot of flexibility and customization. Options traders can use probabilities to set up their trades, which will also impact the position’s reward/risk profile. You can create trades to be as aggressive as you'd like, and can even make money if the stock stays flat.
For example, selling a credit spread closer to the stock’s price will bring in more credit, but may have a lower probability of success. You also have control over the spread’s width, which is another advantage of option spread strategies. Wider credit spreads increase potential profit, as well as the max loss value for both debit and credit spreads.
Volatility's impact on vertical spread option strategies
When trading options, one of the most important factors to consider is the level, and potential direction, of volatility. Implied volatility is a measure of how much the price of an asset fluctuates over time. Higher volatility typically leads to higher option premiums.
If you believe volatility will go down, credit spreads can be used to take advantage of the expected decrease in implied volatility. And since options are relatively more expensive, credit spreads can be a better strategy when volatility is high. Conversely, debit spreads are generally used when vol is lower to capitalize on cheaper premiums to take advantage of an expected increase in implied volatility.
Traders can use IV rank to evaluate a ticker’s relative volatility to its 52-week range to determine if volatility is high or low. Of course, just because IV is low (or high), it can be difficult to predict when it will increase or decrease, but it should help guide you when choosing to buy options or sell options.
The impact of time decay on options vertical spreads
Time decay is a primary factor impacting options vertical spreads. All options lose value as time passes. This effect is referred to as time decay and it is measured by Theta. Time decay accelerates in the last 30 days before expiration.
Options vertical spreads consist of two option legs, a long leg and a short leg, meaning you are always buying one option and selling another, regardless of the strategy type and directional bias. The long leg and short leg are impacted differently by time decay.
Credit spreads benefit from the passage of time. The short option is closer to the money and has a higher delta, so it will lose value quicker than the long leg, ideally allowing you to buy back the spread for less than you sold it. Debit spreads are impacted negatively by time. You'll need the stock to move in your direction quickly to outpace theta decay and realize a profit.
When to trade credit spreads vs debit spreads
Vertical spreads give options traders a lot of flexibility. Credit spreads are typically best used when you want to capitalize on time decay and decreasing volatility. Debit spreads can be a good strategy when you expect volatility to increase and have a strong directional bias. Net long option positions are generally lower probability trades, but they can be set up in such a way to create positive risk/reward profiles, and even have a break-even point that is above or below the current stock price.
For example, this long put debit spread is bearish, but is set up in such a way that the break-even price is actually above the current price, so the stock price could go up and you'd still make money on the trade. The trade even has a more than 50% probability of success and positive expected value (EV).
Similarly, this short put credit spread has high probability and is centered well below the stock price, meaning the stock could drop and you'd still make money if the price is above the short put strike at expiration.
Want more insight and examples on how to use option spread strategies? Don't miss podcast episode 116: Debit Spreads vs. Credit Spreads – When to Use Each.
Using Trade Ideas to Find Option Spreads
Trade Ideas makes it incredibly easy to find credit spreads and debit spreads. You can filter for trading opportunities and sort by IV Rank for the different strategy types..
See how powerful it is to find high IV credit spreads and low IV debit spreads (then simply add additional filters to find your favorite option trade!):