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Debit Spread or Credit Spread?

Posted by Pete Stolcers on May 25, 2006

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.

  • On 08/27, stan stocki said:

    Does a DEBIT spead EVER have an advantage over a CREDIT spread ??

    stan

  • On 08/30, Pete Stolcers said:

    Yes, but not very often. Let’s say that I am bullish on a stock. I could just sell an out of the money put spread, but I buy an at the money call debit spread instead. As time elapses, the stock moves higher and the in the money call moves higher. The out of the money calls loose time value. If the stock looks strong, I can often buy back the short calls for very little and let the stock run a bit.

    If I am trading an at the money or in the money situation I will buy a debit spread so that I don’t have to worry about assignment.

    When I am selling out of the money spreads (widely used strategy), I will always sell credit spreads.

  • On 08/30, bill lawson said:

    No one seems to be able to answer my question about $1.00 option spreads.

    On those options which have $1.00 strike price spreads I always have a big problem deciding whether to sell the $1.00 spread [5 times for example...a 40/41] or to just trade a wider spread [40/45 for example] once.

    With other risk factors being equal, and if premium is the same or favoring the narrow spread, is either one a better choice?

    Does the $1.00 spread[5 times] carry any different risk? or offer any better chance for profit?

    I will consider any answer that I can understand a ‘near miracle’

    Thank you.

  • On 04/18, Mike C said:

    Question on taking profits early on a credit spread position.

    Assume the position really goes your way quickly and the value of the spread goes way down.  Do you have a set percentage where once you have achieved that amount of profit relative to the max credit that you exit the position, and move on to the next trade.

    I’ve been playing with the idea of automatically closing it out once I get to 70-80% of the max profit, especially when there is still 2-3 weeks left to expiration.  Seems to me at that point conceptually you are risking alot for a small remaining reward.

    Does this make sense?

  • On 04/19, Pete Stolcers said:

    There are many traders who would agree with your practice of closing out a credit spread that has little premium left.

    If I have a very compelling trade I want to enter and I need to release the margin, I will buy it back. However, most of the time I let it epxire. I don’t want to waste money on the commissions or the option premium when the probability of success is very high.

    If there is an event (i.e. earnings), I will always close it out. The risk in that situation is much greater than the reward.

    If it is a put credit spread and the market has breached techinical support, I will buy the spread back.

    Evaluate the position risk, then make a decision.

  • On 06/24, Justin said:

    I had something that I dont quite understand (i am still in the stage of virtual trading). I did a credit spread (sell 39 put and buy 40 put). upon expiration, the underlying stock reached 39.5. What happened was I was assigned the stock while both my options expired worthless. What had I done wrong in this case to avoid been assigned?

  • On 06/27, Pete Stolcers said:

    That is a debit spread, you are paying for it. You were long a $40 put and that was $.50 ITM. The broker auto-exercised it because it had value. Anything more than $.01 in the money is auto exercised/assigned. You needed to close the position to avoid that.

  • On 09/09, Newbie Options Trader Jack said:

    Pete,

    I used to be an avid trader of debit spreads, but your blog has converted me into a credit spread trader. So thanks for all your hard work and great information. My question is regarding lot sizes though. This may be seem like a dumb question, but does it make a difference what lot size you trade ? Is there greater probability in profits with say a 10 lot trade as opposed to a 7, 5, or even 1 lot trade ?  Or are bigger lot sizes more attractive to Market Makers.

    I just want to be sure I’m not making a fundamental trading mistake by trading small lots.

    Regards

  • On 09/10, Pete Stolcers said:

    The size of the trade is a function of your confidence in the analysis and your market opinion.

    There will be times when the stock and the market are giving you good trading signals. In those instances, you can increase your size.

    In other instances, you might be less confident in one or the other and you should trim your size or sell farther out of the money options. At times, I will go one strike farther out and do a $10 credit spread ($10 between the strikes) instead of a closer $5 credit spread.

    The size is also a function of your personal risk tolerance.

    From an execution standpoint, the size won’t matter. Market Makers will take a 6 lot just as easily as they will take a 10 lot.

    If you are trading small size, make sure the minimum commissions are not biting into profits.

  • On 09/10, bill lawson said:

    i am repeating this question in hopes of an answer about $1.00 option spreads.

    On those options which have $1.00 strike price spreads I always have a big problem deciding whether to sell the $1.00 spread [5 times for example...a 40/41] or to just trade a wider spread [40/45 for example] once.

    With other risk factors being equal, and if premium is the same or favoring the narrow spread, is either one a better choice?

    Does the $1.00 spread[5 times] carry any different risk? or offer any better chance for profit?

    Thank you.

  • On 09/12, Pete Stolcers said:

    The answer to your question is VERY complicated and there are many considerations.

    Here are a couple of generalities:

    Selling a $5 spread has less risk than a $1 spread. As the stock moves through the short strike price, it has a great distance to travel before it maxes out. In a $1 spread, it is through both strikes immediately.

    The commissions alone will be 5 time higher with the $1 spread and for that reason alone I will prefer a $5 spread.

    If you like to adjust positions, the $1 spread might make more sense. If technical support is breached, you can reel in your short and hang on to the long. It will be ATM and it will pick up premium very quickly vs. its $5 counterpart.

    I can’t get into too many specifics on price behavior, but the time until expiration and the IVs will also play a role in the performance of each.

    I suggest trading each strategy in small size. Get a feel for how they move and which one you prefer.

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