SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Are Debit Spreads Better Than Credit Spreads?


Here are some misconceptions about credit spreads:

  • "One of the many drawbacks of a credit spread is that it will tie up so much capital."
  • “Selling credit spreads is like picking up pennies in front of a steam roller.”
  • "Credit spreads are different from debit spreads. One has a low probability of success, the other has a high probability of success."

I hope that after reading this article, some of those misconceptions will be cleared.

 

The trigger for this article was a conversation I had on Twitter with one of my followers. Here is a snapshot:

 

017a2e035fc42b0cc48ad650491c8be5.png

 

Same Probability? You Bet!

 

The link in my tweet pointed to one of my previous articles where I clearly demonstrated that credit spreads are in fact the same as debit spreads if using the same strikes.

 

I guess that one picture is better than thousand words, so lets try to visualize the concept.

 

Lets try to construct a RUT credit spread having ~80% probability of success. Using August 2014 expiration and July 10 closing prices, we can do the following trade:

  • Sell Aug. 2014 RUT 1210 call
  • Buy Aug. 2014 RUT 1220 call

 

The risk profile looks like this:

 

2d01dfcc7ae0f782135c4a55f388f3b3.png

 

As we can see, we get $185 credit for this trade, our margin is $815 ($1,000-185) and maximum gain is 22.7% (185/815). The maximum gain is realized if RUT stays below 1210 by August expiration.

 

As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5%.

 

Now lets try to construct the same trade with puts. The trade will be:

  • Sell Aug. 2014 RUT 1210 put
  • Buy Aug. 2014 RUT 1220 put

 

The risk profile looks like this:

 

1599bf7b0f476bec2f301b293f06389e.png

 

In this trade, we are paying $815 and our margin is the same as the debit ($815). The maximum gain is realized if RUT stays below 1210 by August expiration, in which case the put spread will be worth $1,000. The maximum gain? 1000-815=185, so 185/815=22.7%, exactly the same as with the credit spread. As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5% - again, exactly the same as with the credit spread.

 

There might be some practical reasons to prefer one trade over another. In our example, the credit spread is constructed using OTM (Out Of The Money) options, that tend to be more liquid and have tighter bid/ask. So while "theoretical" prices might be the same, in practice you might get better fills (which means better probability of success) with the credit spread. In addition, OTM options don't have assignment risk, while ITM options do. That means that you always have to close the ITM spreads before expiration, while with OTM spreads, you can just let them expire. Of course assignment risk is relevant only to American style options. European style options like RUT, SPX etc. can be exercised only at expiration and don't have assignment risk.

 

The bottom line:

 

The trade can be constructed by selling lower strike and buying higher strike. When using calls, we will get a credit. When using puts, we will pay a debit. But if the same strikes are used, this is exactly the same trade. Same risk profile, same maximum gain, same probability of success, same breakeven point.

 

Want to learn more about options?

 

Start Your Free Trial

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • A Global Equity Put Write Portfolio

    Many that sell equity market put options focus on the S&P 500 (SPX, XSP, SPY). Some will add small caps by selling puts on the Russell 2000 (RUT, IWM). An investor could also make their put selling strategy globally diversified by adding MSCI EAFE (EFA) and Emerging Markets (EEM).

    By Jesse,

    • 0 comments
    • 199 views
  • The Random Walk Hypothesis

    The “random walk hypothesis” (RWH) is one idea about how stock prices behave – but only one of many. It is a theory promoted in academia and believed in my many, but not so much by traders involved with handling real money. Theories aside, is the market truly random?

    By Michael C. Thomsett,

    • 0 comments
    • 279 views
  • How To Trade Options Successfully

    I’ve now been trading options for over a decade and been associated with Steady Options for seven years – hard to believe.  Over that period, I’ve learned quite a bit about option trading; how to improve, what not to do, and generally how the option markets work. I’m still learning.

    By cwelsh,

    • 3 comments
    • 525 views
  • January 2019 Performance Analysis

    No one likes losing money, and no one likes hearing "excuses". However, in an effort to be fully transparent, solicit feedback, and to improve our own performance, we're writing this article to do a further breakdown of the losses which our model portfolio incurred in January 2019. 

    By Kim,

    • 17 comments
    • 1,322 views
  • Island Clusters as Strong Reversals

    Options traders constantly seek the elusive reliable reversal signal. A few unusual but strong reversals are worth looking for, and their patterns reveal likely exceptional timing for opening or closing option trades. One example of this exceptionally strong signal is the island cluster (or, island reversal).

    By Michael C. Thomsett,

    • 0 comments
    • 357 views
  • What’s Wrong With Your 401(k)? (If anything)

    There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States.  Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.

    By cwelsh,

    • 0 comments
    • 439 views
  • Upcoming Decay of Options

    I am on the hunt for a short volatility position for three main reasons. First, the market’s wild swings have, for the time being at least, diminished. Second, option activity has dried up as my options barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction.

    By Jacob Mintz,

    • 0 comments
    • 520 views
  • The Scientific Process of Increasing Expected Returns

    For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

    By Jesse,

    • 0 comments
    • 902 views
  • Those Golden and Death Crosses

    The use of moving average (MA) for predicting future price behavior must be undertaken cautiously. MA is a lagging indicator, so the question must be: Can a lagging indicator provide guidance for the future? Yes. The use of two MA lines and how they interact is a reliable form of reversal indicator.

    By Michael C. Thomsett,

    • 0 comments
    • 632 views
  • Trading Reverse Iron Condors When IV Is Elevated

    Our members know that pre earnings straddles and calendars have been our bread and butter strategies in the recent years. We enter those trades when the prices are cheap compared to previous cycles. However, in the last few months of 2018, Implied Volatility exploded, making most of those trades too expensive.

    By Kim,

    • 0 comments
    • 706 views

  Report Article

We want to hear from you!


Guest Ricardo Espinosa

Posted

Great explanation...if they were not the same, you could do arbitrage...buy to open a debit spread and sell the same amount of credit spreads, or the other way around. 

I tend to like short spreads because if the trend changed and the market moves against me, I can always buy to close the short leg and keep the winning long leg.

Share this comment


Link to comment
Share on other sites

They are definitely the same, however is there generally better liquidity on the in the money side, i.e. on the ITM Put Credit Spread versus the OTM Call Debit Spread?

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs