Debit Spread or Credit Spread?

Posted by Pete Stolcers on May 25

Option Trading Question

On 5/24/06 Thomas F. asked, “How do you determine if you will do a credit spread or debit spread?”

Option Trading Answer

That’s a great question. The biggest deterrent to trading options is slippage. The liquidity is poor, the bid/ask spreads are wide and the commissions are high. The fewer trades I have to do, the better.

I use spreads when my confidence in the timing of a move is moderate (as opposed to high). I’m always a directional trader and all of my research looks for those opportunities. The spread allows me to reduce some of the risk exposure and increase the probability of the trade by going out of the money. It also reduces my margin requirement and allows me to generate a higher rate of return based on the capital I have “put up”. I use spreads to sell out-of-the-money (OTM) premium and take advantage of time premium decay. They are high probability trades where I’m willing to risk $4 to make $1. This risk reward ratio only works if you are right more than 80% of the time (assuming you take the max risk on losers). Given that I’m completely expecting the spread to expire worthless and I won’t incur slippage on the way out if the options expire.

The key to this type of trading is to have a stop-out point where you will shut down the trade and admitt that you were wrong. Often I use the strike price that I’m short and if the stock trades at that price, I buy in the spread. This will also keep you out of assignment risk and it will force you to “take your lumps”. This strategy is not designed to take many $4 hits.

I don’t trade debit spreads when I’m looking for a directional move and my confidence is high for a variety of reasons. That discussion will have to wait for another Q&A.

Option Trading Comments

On 11/13, jeff daniels said:
Dear Sir,
Many advisors say buy a few months out,but it makes me nervous when I track an option and within a 2 month period, they all
seem to get whacked up and down(and once it goes down 50% ,it takes twice as long to get back up. Yet I also know people make money
on them. I guess I am asking,"If one if correct on direction, magnitude etc, will they make
money even if a specific option gets whipsawed during the period? thanks jeff
On 11/14, Pete Stolcers said:
Hi Jeff,

Every good option trade starts with accurate market analysis and good stock picking. The option strategy is merely an extension of your opinion. If you get the market right and you get the stock right, you can do almost any strategy and make money. Some strategies will perform better than others because the risk/reward varies.
On 12/10, kevin Zhong said:
Dear sir:

I think your professional at option trading, because I read your comment everyday. The option price seem to change very heavy, even though the stock price changed a little. For example, the QQQQ put option at 28 was $0.50 at Dec.9 when QQQQ was $30,but it change to $0.37 at Dec.10 when QQQQ is $30. WHy it is so different?
Thanks!

Kevin
On 03/22, diane said:
I am confused about expiration day. I was advised that the index SPX expiration is calculated at the open on expiration Friday. I had a Bear Call Spread at 785/790 and the SPX opened at 784.65 but I still lost most of the spread.

When and how is the SPX really calculated on expiration Friday?

Thanks
On 03/23, Pete Stolcers said:
The morning of expiration Friday, each opening print for every stock in the S&P;500 is used to calculate the Set. The set determines where the index settles. I have seen many HUGE 20+ point moves on the opening bell on expiration Friday and the opening prints can actually be the high or low of the day for the stock the entire day.

You can find more info at www.cboe.com.

Always know the settlment before you trade the underlying. The VIX and OEX each have very different settlements.
On 05/20, harry kay said:
how does one calculate the probability of assignment(%) on a naked put ?

thank you
On 05/27, Pete Stolcers said:
If you are asking how to calculate the probability that the stock will move throught the short strike price, you use the stock’s historical price movement.

If you are asking how to calculate the probability of assignment once the option is in the money, it is a function of intrinsic value. If the option is trading under parity, there is a very high probability of assignment. If there is time premium left in the option, the probability is low.

If you are not familiar with the option terms, please read the definitions on the home page.
On 09/02, WILLIAM LAWSON said:
In writing credit spreads I am often surprised when my ‘account’ will not let me continue
and stops me with a complaint like’You need XXX $ more in your account to complete this transaction when my inspection appears to show that I may have plenty of money left to do more credit spreads.

How do I calculate, as my brokerage account does the amount of ‘risk’ in these trades and so how to proceed in writing bear call and bull put credit spreads?
On 09/03, Pete Stolcers said:
It is not the amount of risk that you need to calculate. Brokerage firms set their own margin requirements and they need to be at least the exchange minimum. You need to contact your brokerage firm and they need to explain their margin requirements to you.

If they are way above the exchange minimum margin requirement, you may need to find a new brokerage firm.
On 03/15, Ray said:
I’m trying to diversify my trading and looking at credit spreads. I’m trying to figure out how you exit a losing trade?
Since a credit spread channel will probably always have one side threatened eventually before expiration at some time, I do not understand the part about when to exit. Since you sell and buy, out-the-money, the references mentioned ‘close’ if the OEX index ( which is what I trade buying positions normally ) moves to the side of the credit spread I sold. But some references mention it is the index you should watch and you should ‘close’ if the index returns to the starting point, when you put on the out-the-money credit spread. Which is it?
On 03/15, Pete Stolcers said:
In the case of a bullish credit spread (you think the stock will hold its own or move higher), you want to define support. That can be horizontal support, a trend line, major moving averages or any combination thereof. You want to sell the put spread below that defined support. Once the support is breached, you have to buy the spread back in and admit that your analysis was wrong.

Debit Spread or Credit Spread?

Option Trading Question

Option Trading Answer

Option Trading Comments

Leave a comment or question on options trading

Categories

Resources

Option Trading Q & A

Free Option Trading Event