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Debit Spreads Vs. Credit Spreads


 

There is a lot of confusion and misconception about debit and credit spreads. One of the most common misconceptions:

"One of the many drawbacks of a credit spread is that it will tie up so much capital."

Another misconseption:

“Selling credit spreads is like picking up pennies in front of a steam roller.”

 

Lets address those misconceptions.

 

The simple truth is that credit and debit spreads require exactly the same capital. You just have to compare apples to apples. Lets look at July AAPL options as an example.

Trade #1:

  • Buy AAPL July 2012 600 call
  • Sell AAPL July 2012 590 call

 

Trade #2:

  • Buy AAPL July 2012 600 put
  • Sell AAPL July 2012 590 put

 

Both trades are bearish - the maximum gain is realized if the stock is below $590 by July expiration. If the stock stays above $600, both trades will experience the maximum loss.

 

In the first trade, you get a $788 credit. The margin requirement is $212 which is the difference between the strikes less the credit received. If the stock is below $590, both options will be worthless and you keep the whole credit. The maximum gain is 271% (788/212).

 

In the second trade, you pay a $214 debit. The maximum gain is realized when the stock is below $590, in which case the spread will be worth $1,000. The maximum gain is 267% (786/214).

 

The maximum gain of the first trade is slightly higher than the first trade, but the difference is very small. The capital requirements and P/L profiles of both trades are very similar, almost identical.

 

The bottom line: what determines the P/L graph of the spread is not the credit or debit, it’s the strikes you are using. The same trade can be done for credit or debit, using calls or put. As long as the same strikes are used for both trades, the results will be very similar, almost identical.

 

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