Debit Spread Vs Credit Spread: What Is The Difference?

Debit Spread Vs Credit Spread: What Is The Difference?
Debit Spread Vs Credit Spread: What Is The Difference?

In the world of vertical spreads, there are credit spreads and debit spreads.  What is the difference between Debit Spread Vs Credit Spread and how do investors use these strategies?

When an investor chooses a credit spread or net credit spread, he is simultaneously selling an option with a higher premium and buying an option with a lower premium, usually on the same security but at a different strike price.  This results in a credit to their account.

What Is Debit Spread Vs Credit Spread?

A debit spread is the reverse: an investor buys an option with a higher premium while simultaneously selling an option with a lower premium on the same security, resulting in a net payment or debit to his account.

Read on to learn more about the differences between credit and debit spreads and how volatility can affect each.

ALSO CHECK: Equity Multiplier Formula: Best Easy Guide to Calculating

What Is Credit Spread?

In a credit spread, an investor sells an option with a high premium and buys an option with a low premium on the same security.  These trades result in a credit to the trader’s account because the option they are selling is worth more than the option they are buying. 

In this scenario, the investor hopes that both options will be out-of-the-money at the expiration date and lose value, allowing the investor to keep the original net premium collected.

ALSO CHECK: Reflation: Definition And How It Works

What Is Debit Spread?

In a debit spread, an investor buys an option with a high premium and sells an option with a low premium on the same security.  These transactions result in a debit from the trader’s account. 

But they make the trade with the expectation that a change in price during the life of the option contract will result in a profit. 

The best case scenario is that both options are in the money at expiration, allowing the investor to close both contracts for maximum potential profit.

ALSO CHECK: Consumer Auto Credit: 2022 Reviews

Difference Between Debit Spread Vs Credit Spread

Given so many factors, investors have developed many strategies for trading options.  A vertical spread comes in two varieties—a credit spread or a debit spread.

This may involve the purchase (or sale) of a call (or put) and the simultaneous sale (or purchase) of another call (or put) at a different strike price but with the same expiration date.  Let’s take a look at these two options trading strategies – Debit Spread Vs Credit Spread.

When trading a credit spread option, the trader sells an option with a high premium and at the same time buys an option with a low premium. 

Due to this and the difference between the two premiums, i.e. the premiums on the two option contracts, the premium is credited to the trader’s account when he opens his positions.

Both types of option spread trading strategies involve buying and selling options related to the same underlying asset. 

While a credit spread involves selling an option with a high premium and simultaneously buying an option with a low premium, a debit spread involves buying an option with a high premium and selling an option with a low premium, resulting in a debit to the trader’s account when he opens his positions.

In credit spread options trading, the main focus is on making money through this difference in the premiums of options bought and sold.  It is preferred by more experienced hands compared to the counterpart sought by novices.

ALSO CHECK: Consolidated Financial Statements: Example, Meaning, Comparisons

How Does A Credit Spread Work?

One important note is that credit spreads require traders to use margin borrowing because if both options are in the money at expiration, their short leg will be more valuable than their long leg. 

So, before a trader can use a credit spread, he needs to make sure his brokerage account is set up properly.

Strategy has two forms.  The first credit spread strategy is the rising put credit spread, where an investor buys a put option at one strike price and sells a put option at a higher strike price. 

Put options tend to increase in value when the price of the underlying asset falls, and they tend to decrease when the price of the underlying asset rises.

Therefore, it is a bullish strategy as the investor is hoping for the price of the underlying asset to rise in such a way that the expiration of both options will lose their value. 

If the price of the underlying asset is higher than the higher strike price set on the expiration date, the investor receives the maximum potential profit. 

On the other hand, if the underlying security falls below the strike price, the investor will experience the maximum potential loss of the strategy.

ALSO CHECK: Billing Statements: Templates & All You Need

How Does A Debit Spread Work?

A debit spread is the inverse of a credit spread.  Like a credit spread, a debit spread involves buying two sets of options on the same underlying security with the same expiration date.

But in a debit spread, the investor buys one set of options with a higher premium and sells a set of options with a lower premium.

While a credit spread strategy results in a net credit to the trader’s account when he executes the trade, a debit spread strategy results in an immediate net debit to his account, hence the name. 

The debit occurs because the premium paid for the options the investor buys is greater than the premium the investor receives for the options they buy.

Investors typically use debit spread strategies as a way to offset the cost of buying an expensive option outright.  They may choose a debit spread instead of buying a single option if they expect modest fluctuations in the price of the underlying asset.

ALSO CHECK: What is Debt Service? What You Should Know

Calculating Profit Targets On Debit Spread Vs Credit Spread

Credit spreads

Let’s say you sell a $5 popular product for $2.50 in credit.  Your maximum loss is always the width of the spread minus what you took out as a loan.  In this case, it is a maximum loss of $5.  This trade will give you a 1:1 risk to reward ratio. 

The maximum profit you can make is $2.50 as this is the credit you received when you sold the spread.  To find 80% of $2.50, multiply 2.50 by 0.80, which equals $2.00. 

Then subtract your loan by 80%.  For example, $2.50 minus 2.00 equals $0.50.  So, if you are trying to reduce your spread to 80% of your maximum profit, you can set a Good till Cancel order at $0.50 and wait for theta decay and price action to work in your favor. 

Since you are selling the premium with the hope that it will decline and go straight to your account, hopefully you can buy back the spread for less than you sold it to get out of the trade at a profit. 

In case the trade goes against you, you will have to buy it back for more than what you sold, creating a losing position in your account.

Debit spreads

In the case of a debit spread, you buy premiums, not sell them.  Your maximum profit is equal to the width of the spread.  For example, you can buy a debit spread for $2.50, which equals $5.  The maximum price you can sell it for is $5. 

To calculate your maximum profit, you take $5 and multiply it by $0.80.  The calculation is $5.00 multiplied by 0.80, which equals $4.00.  So if you pay $2.50 and want a spread of 80% of the maximum profit of $4.00, you would expect to make about $1.50 on the spread. 

The most you can lose is the amount you paid.  You need the price to go up so you can sell it for more than you bought it for.  If it loses value, you lose money.

Conclusion

If you’re looking for an investment strategy with high profit potential and lower risks, options trading is a great place to start.  Although options trading can be a little difficult for beginners, there are many tools and strategies available that a novice trader can start to take advantage of, generating healthy profits month after month. 

Spreads are the basic building blocks of several options trading strategies and some of the simplest options strategies a trader can implement.  A spread can be classified in many ways, one of which is whether the strategy is a debit spread or a credit spread.

Debit Spread Vs Credit Spread FAQs

What Is Credit Spread Formula?

The credit spread formula multiplies one minus the return percentage by the probability of default.  The full formula is:

The recovery ratio allows an investor or trader to estimate the amount of the loan they would still receive if the bond issuer defaulted on its repayment obligations.  Higher repayment percentages are always better because a 100% repayment percentage means that the borrower will repay 100% of the amount that was borrowed

What Are Vertical Spreads?

Vertical spreads are an option strategy that involves buying an option and selling another option with the same expiration date on the same stock.  When you use two different options in the same strategy, they are called legs.

How Do You Calculate The Maximum Value And Maximum Risk Of A Vertical Spread?

It is easy to calculate the maximum value of the vertical spread.  You simply subtract the two strike prices from each other and multiply by 100 (remember that options are contracts that represent 100 shares of an asset).  For example, if you have a vertical spread of 100/90, the maximum value is $1,000.

References

  • sofi.com – Debit Spread Vs Credit Spread

EDITOR’S RECOMMENDATION

0 Shares:
Leave a Reply

Your email address will not be published.

You May Also Like