Lesson Overview

Debit Spread or Credit Spread?

Choosing between using a debit spread or credit spread for a bearish stock setup requires that we first take a look at where implied volatility is trading. If IV is high then we want to be a net seller of options and would opt for selling the credit call spread above the market. If IV is low then we want to be a net buyer of options and would alternatively opt for buying the ATM put debit spread.

Show Video Transcript +

In today's video, we’re going to break through one of the questions that I get a lot from members and students that I coach, and that’s trying to figure out if you should trade a bearish debit spread or a bearish credit spread.

If you’ve decided that you’re bearish on a future direction of some stock or ETF, that's great. But should you choose to trade a debit spread or a credit spread? The question is, “Should you choose an options strategy where you’re a net buyer of options or a net seller of options?”

In this video, we’ll help you figure it out or help you figure out which strategy is best for you for the current market and it all starts by analyzing current implied volatility rank or percentile.

Let’s go here to our broker platform on Thinkorswim. I've got currently up a stock chart here for Wells Fargo which is ticker symbol WFC.

What you’ll notice is that Wells Fargo is just in a little bit of an uptrend here and we’re just going to assume at this point that you think maybe this uptrend is coming to an end and the stock might come back down lower.

You’re looking at this chart, and for some reason, your technical’s or your support and resistance lines tell you that the stock is going to go lower, so you’re bearish on the stock.

Now, the question becomes “What strategy do you choose?” What we’ve got down here below is we’ve got a chart of implied volatility. This is where it all starts with choosing the right strategy.

When implied volatility is relatively low going back over the last year, then we favor choosing a debit put spread in this particular instance.

Right now, implied volatility is currently sitting at about 18.6% on Wells Fargo, and you can see that that is pretty low going back over the last year.

If we just draw a line in the sand here going back to the left, you can see that implied volatility has been much higher than that many, many times before in the past and there was not too much more room here for implied volatility to fall.

In this case, we're going to look at that IV percentile and we can see that implied volatility for Wells Fargo is in the 23rd percentile, meaning that over the last year, implied volatility is sometimes higher than this about 75% of the time or can be higher than this about 75% of the time.

This is a relatively low implied volatility market for Wells Fargo right now which means we have to favor strategies that make us net buyers of options because a rise in implied volatility will help our position.

In this case, again, we’re going to choose with Wells Fargo to do a debit put spread and trade this directionally bearish. Let’s say that you wanted to trade something else, maybe like GLD which is gold.

Gold is currently on a huge move up and for whatever reason, you think the technical's or some support resistance lines suggest that gold could make a very big move down in the next couple of days or weeks and you want to trade it bearish.

We’re going to do the same thing, and we’re going to look at where implied volatility is in its historical range for gold, and you can see it's relatively high in this case.

A reading of .2132 which is 21.32% on GLD is a relatively high level of implied volatility, and you can see that the IV Rank is 71%, meaning 71% of the time over the last year, implied volatility is lower than where it is right now in gold. This gives us a great idea of where gold might go in the future as far as implied volatility.

It's going to go down, or it has a better chance of going down than up at this point and what we’re going to do is we’re going to target strategies that take advantage of implied volatility going down and that strategy, in this case, would be a credit call spread above the market.

You would look to sell options somewhere above the market, maybe at a 128 strike or a 129 strike, but you’re looking to be a net seller of options because implied volatility is higher. I hope this video helps out.

Like I said before, if you have any comments or questions on these trades or how to distinguish between a debit spread and a credit spread, please ask them right below on the lesson page. Until next time, happy trading!

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