The Problem With Debit Spreads.

Posted by Pete Stolcers on May 26

In today’s option trading blog, I will look at positions that last three months or less and I will describe why I don’t like debit spreads. A debit spread is created by buying a closer to the money option and selling a farther out option. There are a number of issues I have with this strategy.

If I’m looking for a big move and I’m considering an out of the money spread, why not just buy the long call/put? Chances are that I’m capping off my profit and receiving very little in return by selling an option that is two strikes out. The premium I sell offers little protection and I will have to fight another bid/ask spread and incur another commission charge. To complicate matters, as the spread “goes your way”, the option you sold will pick up speed along with the one you bought and your gain is muted. This result frustrates traders and prompts them to overstay their welcome. If they were just long the option, they would be realizing nice gains and taking profits. Many times I’ve waited for a spread to widen out and the false sense of security has kept me in the position. The next thing I know, the stock reverses and the profits are gone after I battle two bid/ask spreads to get out. There is nothing worse than being right and not making money. Sound familiar?

If you are looking at an in-the-money (ITM) call debit spread, you are saying that you think the stock will go up a little or at least stay flat. In that case I suggest an out of the money put credit spread. You will have two bid/ask spreads to fight (not four) and half the commission charges. This assumes that you are right more than half of the time and your puts expire worthless (no commission or action required). If you are right less than half the time, you won’t have to worry about credit spreads or debit spreads or slippage. You’ll be looking for your next career… “Would you like to super size that?”

Bottom line: If a stock is going to make a move and your confidence is high, don’t spread. Buy the option. If you’re fairy sure and you want to play it safe, sell an out-of-the-money credit spread.

Posted in, Option Strategies - Good and Bad!

Prior 4 Daily Reports

Yesterday’s Decline - Lack of Buying Late - Short-Term Lows Are Near!October 9
Global Interest Rate Cut - If The Market Is Up After 3:00 ET - Get Long!October 8
On A Short-Term Basis - Support Is Near - Place Stops On Bearish Positions!October 7
Market Crashes - Prepare For A Capitulation Low - Be Patient!October 6

Option Trading Comments

On 06/07, Tom said:
I agree...just buy the option. But i have been finding more people saying to sell options instead of buying them since according to the exchanges 80% of all options expire worthless. It seems to me that if you have something that pays a profit 80% of the time then everyone would join in and all the buyers would vanish. I am having a difficult time accepting this since I think there is a great deal of missing information. I still maintain that there is money to be made buying options if one adheres to good money management rules and creates a valid plan of action and then has the perseverance to stick to it. Can anyone justify that 80% of the sellers constantly make money?? Thanks
On 09/23, spreadtrader said:
I started trading debit spreads a little while back and have noticed some of the things that you’re talking about. It’s true that while the long option gains, so does the short to offset your profit, but its also there to make the cost of the entire trade less and therefore you risk less. Also, the short option will also offset some of the theta bleed of the long option, correct? According to my option calculator, if I just buy the long OTM option and hold for 30 days (my particular timeframe) and I buy an option about 3-4 months from expiration, I can easily lose 10-20+% just on theta. This is the part that really bothers me. And I haven’t really understood this yet, but it seems to shield me a good bit from IV fluctuations. I still have to study why this is so, but I’ve had good calls go bad because of IV. The less I have to worry about IV, the better. I can confirm most of what you’re saying. The double commission stinks, the increased b/a spread stinks, but theta stinks too. I’m still going back and forth in my own mind as to which approach is better. I’m actually going to try some simple buys of calls/puts next week to see if the theta is going to be as bad as my option calculator tells me. I appreciate any insight that you can provide.
On 09/23, Pete Stolcers said:
High confidence, fast move equals long put or call. As my confidence decreases and my time horizon for the move grows, I’m more inclined to spread. I find very few reasons to ever debit spread. For every debit spread, there is an equal credit spread. Credit spreads will resolve your theta issues and if you are right more than you are wrong, the spread will expire worthless and you won’t have slippage or commissions on the way out. If you are wrong more than right - you’ve got bigger problems to address. There is a credit spreading post you may want to read.
On 09/24, spreadtrader said:
You make very good points. I noticed the other day when I was pricing a debit spread that a credit spread was nearly identical as far as risk/reward. The time horizon that I have (about 20 trading days or approximately 1 month) shows the best profitability with my system. Anything shorter and it gets closer and closer to a coin flip. As of recent, I’ve been trading OTM debit spreads 3-4 months from expiration. Based on your response, I think I’ll try front month OTM credit spreads instead. Thank you for your comments! I truly do appreciate it.
On 09/24, spreadtrader said:
One thing I thought of with a credit spread vs. a debit spread is assignment. With the debit spread, I’m typically buying OTM options it seems and not so much so with the credit spread. I understand this happens approximately 17% of the time. If the stock is @ 66 and I buy a 65 put and sell a 70 put (bull put spread) and the stock doesn’t move, I have options that are at risk of being assigned. Is this just the chance you take?
On 09/24, Pete Stolcers said:
If your level of confidence was fair, you might be better served to sell the 65-60 put spread and give yourself a little "cushion". The stock can move $1 lower, stay flat or go up and you will make money. If your confidence level is higher, you might consider just being long the 60 or 65 call. The opposing debit spread in your example would be the 65 - 70 call debit. In that trade you will need to consider how much premium you are bringing in on the 70 call. Often, it’s not worth "capping" your upside, taking on the slippage and paying extra commissions. These are just generalizations and every trade is unique.
On 07/15, Mark said:
I recently finished reading larry mccmillans options as a strategic investment. He noted that he prefers the the debit spread because you are not indangerd of getting assigned? any thoughts on that? Also most of my options trading I have learned from mccmillan Is he a good source? do you agree with his style are there any other great books Im missing ? (I also read options pricing and volatility by natenberg) Thanks
On 07/16, Pete Stolcers said:
Larry is a great friend and I have a deep respect for his research.

I don’t recall reading that in Larry’s book and I wonder if that was taken out of context. Larry is not one to make blanket strategic statements.

I like OTM credit spreads as opposed to ITM debit spreads (any debit spread can be configured to be a credit spread). I have to assume that more than half of the time, I will be right. Consequently, the credit spread will expire worthless and I won’t have any commissions or slippage on the way out. If I am wrong more than 50% of the time, I’d better find a new line of work.

If I am looking for a big move, I would rather buy an OTM debit spread than sell an ITM credit spread for the reasons Larry mentioned (assignment).

You have read the best two books on options - congratulations.
On 08/13, Mike C said:
Hi Pete,

Just discovered your blog from a link over on the OptionPundit blog. Been reading a bunch of the articles. Great stuff you’ve got here.

Question on this one as far as problem with debit spreads. Wouldn’t they be more effective/better idea then just long calls for this type of situation:

Stock XYZ has had a sharp furious correction (30 to 40% in a month) after a substantial short-term uptrend (up 100% in 6 months) back to a long-term uptrend line, and as a result IV is literally through the stratosphere at 1-year highs, and you are playing for a decent sized bounce off the long-term uptrend line.

Wouldn’t going just the long call expose you to massive IV implosion that results in a loser or much lower gains even if you get the bounce right, whereas the spread immunizes you from IV collapsing?
On 08/13, Pete Stolcers said:
You are correct. High IV’s require a spreading strategy (unless you are comfortable with naked shorts). You need to sell that inflated premium. Remember that for every debit spread, there is an equivilent credit spread. For example, buying the 50 - 55 call spread for a $3 debit is equal to selling the 55 - 50 put spread for a $2 credit. In general, I like selling out of the money front month spreads. This is high probability trade and it takes advantage of accelerated time decay. If I am long term bullish and I expect a big move, I might sell a front month OTM put spread to finance a back month OTM call debit spread.

Thanks for a good question.
On 08/14, Mike C said:
Thanks Pete for the reply,

Follow up question, kinda funny you mention the 50-55 spread, as that is the exact strikes I was looking at. FWIW, the stock is currently trading at $47ish, and I am looking to be somewhat aggressive on the bullish side as I am expecting a decent size bounce off the correction plus there is a seasonal factor working in favor of the stock moving up.

You seem to have a preference for put credit spreads over call debit spreads because of the potential to avoid another set of commissions and bid-ask spreads. Would that still hold true in the case where you are selling an ITM put spread?

Isn’t it correct that sometimes there could be a variation in the put and call skews and the put credit spread might be just a smidgen different from the call debit spread. Should you compare the two and go with whatever might be just .05 or .10 better?
On 08/14, Pete Stolcers said:
You’ll find that the put credit spread and the call debit spread trade at the same risk/reward adjusted price regarless of skew. The Market Makers are indifferent to which one you do and the positions are identical. The exception to this is an ITM spread on a cash settled American style options like the OEX. Often the premium on ITM credit spreads is more expensive because of the asssinment risk.

The Problem With Debit Spreads.

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