Lesson Overview

Debit Spread or Credit Spread?

Choosing between using a debit spread or credit spread for a bullish 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 put spread below the market.

If IV is low then we want to be a net buyer of options and would alternatively opt for buying the ATM call debit spread.

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In today's video, we want to talk about how you decide between doing a bullish trade in a debit spread or a credit spread format. If you’ve decided that you're bullish on some future direction of stock or ETF, that’s great, but should you choose to trade a debit spread or a credit spread…

And often, this is a question that I get so many times from our members and from students that I coach, is that they just don’t know which way to go with a debit spread or with a credit spread.

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

As we always say and as we have in our downloadable PDF strategy guide which you can find at optionalpha.com is that it all starts with understanding where you think the market might go.

In this case, we’re already bullish, so that's good. The next step is to determine where implied volatility is because volatility is our edge in the market trading options, so we want to have a good understanding of where implied volatility is.

I have two examples that we’re going to go through here tonight on our Thinkorswim platform. The first example is EEM, and this is an emerging market’s ETF. Let’s just say that for some reason, you’re directionally bullish on this stock.

It did have a pretty good breakout today, and MACD and some of the other technical indicators are pointing towards a higher move. I agree that it could be a play for the bullish direction.

It could be a move higher in the next couple of weeks. But now, the question is – Do we do a debit spread or a credit spread? In this case, we’re going to choose to do a debit spread because implied volatility is very low.

You can see that the IV percentile here or the IV rank is at 35 and that means that historically, going back over the last year, implied volatility is usually higher than where it is right now. It's only lower about 35% of the time.

You can see here graphically this purple line on the chart, this is IV percentile, and you can see just going back here historically over the last year that a lot of times, implied volatility has actually been much higher than it is right now, so we’re actually getting into the market during a relatively low period in implied volatility.

As options traders, we want to target or focus our trades on the strategies that work for this market. The two things that we know absolutely at this point is that the stock may go higher, I guess we don’t know absolutely if stocks can go higher, but we assume that the stock is going to go higher and we know that implied volatility is low.

In this case, we want to choose a debit call spread which would take advantage of the lower implied volatility market and the relatively cheap options that are out there.

The other trade that we want to go over today is XLU. XLU is a utility ETF for the spiders. We’re sticking with the ETFs here. You can build the case for the fact that this stock has continued to move up all throughout the end of last year, at the beginning of this year and in May, it breaks out here from the 49/50 range that it's currently in.

Same thing that the indicators are still showing, that it could be continuing higher from here, so I get that the stock could move higher. The next question is – Where is implied volatility?

We can see visually on the chart with our code here that implied volatility is in the 76th percentile. What that means is that 76% of the time over the last year, implied volatility has been lower than it is right now.

You can see visually on the charts just using this dot and going backward in time here that the vast majority of the time over the last year, implied volatility has been much lower than its current reading.

As options traders, we can take advantage of this by selling options as part of a credit spread strategy. In this case, we would sell a put credit spread below the market and take advantage of the rich implied volatility premium that's already on the market.

That’s one way that we can decide on which strategy we choose. Remember, when it comes down to picking whether you choose a debit spread or a credit spread, it’s all about analyzing current implied volatility in the market.

If you guys have any questions or comments about this video, please ask them right below in the comment section for this lesson page. Until next time, happy trading!

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