Students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread? This is inherently a discussion that could fill a thick book so I will just try to give you a few thoughts to consider.
Risk and Reward
A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is many times initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless. For example, if a stock is trading at $50 and an option trader expects the stock to move about $5 higher the trader could buy a 50 call and sell a 55 call. If the 50 call cost the trader $5 and $3 was received for selling the 55 call, the bull call (debit) spread would cost the trader $2 (also the maximum loss) and have a maximum profit of $3 (5 (strike difference) – 2 (cost)) if the stock was trading at or above $55 at expiration. Thus the risk/reward ratio would be 1/1.5.
If the option trader was unsure if the $50 stock was going to move higher but felt the stock would at least stay above a support area around $45 the trader could sell a 45 put and buy a 40 put. If a credit of $1 was received for selling the 45 put and it cost the trader $0.50 to buy the 40 put, a net credit would be received of $0.50 for selling the bull put (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $45 or higher at expiration and the maximum loss is $4.50 (5 (strike difference) – 0.50 (premium received)) if the stock is trading at or below $40 at expiration. Thus the risk reward ratio would be 9/1.
The risk/reward ratio on the credit spread does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move higher at some point to profit. If the stock stays at $50 or moves lower, the calls will expire worthless and a loss is incurred from the initial debit ($2). With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move above $50, trade sideways and even drop to $45 at expiration and the credit spread would expire worthless and the trader would keep the initial premium received ($0.50). I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way depending on how the spread is initiated.
Another thing to consider when considering either a debit or credit spread is the implied volatility of the options. In general, when implied volatility is low, options are “cheap” which may be advantageous for buying options including debit spreads. When options are “expensive”, it may be advantageous to sell options including credit spreads. Option traders that are considering selling a credit spread should also take into account if the implied volatility is perceived as being high. Just the opposite, option traders that are considering buying a debit spread prefer the implied volatility to be low. As a general rule of thumb, I look at the 30-day IV over the last year and make note of the 52-week high and 52-week low. If the current 30-day IV is below 50% (closer to the 52-week low), I look at it is more of an advantage to do a debit spread over a credit spread. If the current 30-day IV is above 50% and closer to the 52-week high, I look at it as an advantage to implement a credit spread over a debit spread. I will not change my outlook like switching to a debit spread from a credit spread because the IV is relatively low. If this is the case, an option trader should maybe consider looking somewhere else for profit.
There are several factors to consider when choosing between a debit spread and a credit spread. The risk/reward of the spread, the probability of the trade profiting, the implied volatility of the options and the outlook for the underlying are just a few to consider. A trader always wants to put the odds on his or her side to increase the chances if extracting money from the market.
Senior Options Instructor