How you pay for a contract matters.
One of the many ways that options traders secure their position is through the use of spread trading. This technique helps offset the risks of taking an option position by selling off another one. From bulls and bears to ratios and boxes, there are many different types of spreads.
The best place to start, though, is at the beginning. First, it makes sense to understand the credit vs. the debit spread.
What is a spread?
A spread is when you, the trader, both buy and sell an option contract on the same underlying asset. For example, you might purchase a call option on GameCo then turn around and sell a call option contract on that same company.
The strike prices and expiration dates can differ, but the underlying concept is to secure yourself against loss by taking offsetting positions.
What is a credit vs. a debit spread?
One of the keys to opening a spread is the price difference between your two positions.
Upon selling an option, you collect a premium for the contract. By the same token, when you buy the contract involved in your spread you will pay a premium for it. That difference is what makes a credit vs. a debit spread.
If you collect more from the contract you sold, you will receive a credit and have (appropriately enough) a “credit spread.” If you pay more for the contract you bought, then there is a debit on the total value of the trade and you have entered a debit spread. (Then there’s the strangle, where you buy a call and put position on the same asset.)
Let’s use an example from our old friends at GameCo.
GameCo is currently trading at $10 per share and you want to enter a call spread with strike prices set at $15 and $20. (You think GameCo is about to do really well.) The premiums are $2.50 and $1.50 respectively.
Selling the $15 position and buying the $20 position creates a credit spread, because you will have sold the more expensive position and receive a $1 credit. This is also known as a bear call spread.
If you sell the $20 position and buy the $15 position, you will have bought the more expensive contract. This is a debit spread because your account will take a $1 debit. This is also known as a bull call spread.
Why does it matter?
In one sense, this is a term of art. Except in the highly unlikely situation where the premiums cancel each other out virtually any spread is either a debit or a credit. So, to a degree, knowing whether a spread is a credit or a debit is largely descriptive.
At the same time, however, thinking things through in these terms can be very helpful.
A debit spread requires that you have the liquidity in your portfolio to cover the debit in addition to whatever margin you incur by selling the contract. (The margin is how much you pay if the contract you sold expires in the money.) Meanwhile a credit spread will add to your total liquidity, although that will be more than offset by the margin as well.
Keeping this in mind will help to frame the position you are taking in terms of credit, exposure, and liquidity.
Qualifying a spread as a credit or a debit is not in and of itself definitive. In many cases this is a distinction without a difference because, again, whether a trade takes a credit or debit does not say much about the overall position itself.
That does not mean this is irrelevant though. Learning the terms of art, and how to frame your thinking, will go a long way toward helping you build your position in the market.
Thinking through the market is very helpful, and every bit of information helps. Get the information you need by trying Market Timer for one month.