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The Problem With Debit Spreads.

Posted by Pete Stolcers on June 5, 2009

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 fairly sure and you want to play it safe, sell an out-of-the-money credit spread.

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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.<br><br>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.<br><br>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.<br><br>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.<br><br>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.<br><br>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.

  • On 08/26, dauddy said:

    Hi,
    I am new here and also in the option business.
    I am wondering, I have been doing bullput (OTM) and bearcalls (OTM) recently, but I have not got the tips when to cut loss when stock price goes ITM. For example, now I have :
    MSFT Sep, -21P & +20P; -25C & +26C total credit $95.25 out of 500$ margin.
    Could you suggest when to cut loss if MSFT ever go way up or down?
    Thank you…
    Dauddy

  • On 08/26, Pete Stolcers said:

    First of all, I don’t like neutral trading swtrategies like iron condors. You are neither bullish nor bearish on the underlying. I am a directional trader and I form concrete opinions on the direction. When my forecast is wrong, I know it.

    For a put credit spread (bullish put spread) I am looking for a strong stock that is moving higher. If the market is choppy, I might want to sell a put spread instead of buying calls.

    I want to make sure there are multiple suppoort levels (moving averages, trendlines, hoirizontal support) between the stock and the short strike price. As the support levels are breached, I have confirmation that I am on the wrong side of the trade and I need to shut it down. I do not like letting the puts go in the money. If I have not already closed the trade, the strike price is the final stop price.

  • On 01/05, Marc said:

    Hello Pete,

    Thank you for your post.

    You can’t make blanket statements as you have about credit vs debit spreads. Try your idea from March ‘09 until now, and you would have been slaughtered using credit spreads.

    Also, many folks may not be able to handle the anxiety of being in a credit spread, worry about whether they’ll be in for nice sized losses. I used to do a lot of condor work on the SP500 futures. Yes, money was made, but God help you if a strong trend gets underway! Potentially, good bye account!

    Folks, it really depends. Debit spreads are nice if you think the stock is going to go up, period. If you want to pile on top of that your thought that the stock will go up quickly, then perhaps do a long call. But even this depends on where the IV is at, at the time. If it is very high, you could get IV crush as the stock rises, and still end up with no gain.

    Buying long puts may be better than doing put spreads though. Why? Because, often during a stock’s down move, the IV goes UP, thus helping your position two ways: downward direction + IV increase. You do a put spread, and that IV increase will not help you, or I should say it minimally aids you. Sure, you do a put credit spread, and that same IV increase (which often naturally happens when an equity falls quickly), and you find yourself peeing your pants, because not only is your short side increasing because of the stock falling, but your IV is too...Yes, the long put helps tremendously in taking off the IV increase onslaught, but you still get the effect to a small degree.

    Credit spreads are great in certain market conditions: An exhausted market to the upside or downside, extremely high IV, and large numbered in value underlying (like the SP500 futures options), where you can go way way way OOTM and still capture a decent premium.

    If you are just starting, stick with debit spreads. Those telling you that credit spreads are better by looking at the math, have not traded in all conditions; certainly not using them! They will tell you that you can roll down/up, but this can become a very silly and expensive game, where you can potentially rack up much higher losses because you are often adding more contracts in your credit spreads to break-even in your rolling exercise.

    Beginners: Stick with Debit Spreads please…

    Marc

  • On 01/05, Pete Stolcers said:

    For every debit spread there is an equivilent credit spread. Credit spreads should be used when selling out of the money premium. As long as you buy back the spread when it goes in the money, you won’t have assignment risk. You will save on commissions when the trade works out because you don’t have to close the spread - it expires worthless. You do have to close a debit spread and in addition to commissions, there is slippage closing it out (bid/ask spread).

    Many other points you make are accurate and debit spreads do have their place.

    Thanks for the post.

  • On 01/26, Christian said:

    Hi,

    I just found your site, and I love it. You have great insight, and your writing style is very informative for those who are just getting into trading.

    I do have a question...I have studied Forex trading for several years now, and traded with some (small) success for some time, but, for several reasons, have decided to shift into trading options. So, I am now learning options and trying to develop a strategy that will be profitable.

    So,I purchased a course/trading strategy off the the internet, for $200. The course itself is valuable, just from the information he gives on “how to” place trades, etc, and his strategy that he teaches seems great as well, but I wanted to see what your opinion is.

    He teaches you to buy Double Calenders, on two specifc market-ETF underlying stocks, and sell Iron Condors, on two other ETF underlyings as well. You enter these front-month option positions about 40 days before expiry. So every month, you have a total of four positions. You size the number of contracts based on how large your account is. His strategy is to find the support and resistance points for these ETF’s and then open the positions based on these points, on the hope that the price will not break out of that range.

    Now, I know that 80% of the time, these strategies work, but it is the 20% of the time that can wipe you out, and he even admits in his video that people will tell you as such, but here is the next angle, he says that most of the time, people place these kinds of trades and then let them run into a losing point at expiration; but that most of these losing trades can be “saved”. His technique is to make “adjustments” when the price of the underlying moves too far against you. For the double calendars, he advises to simply lay another Double Calender on top of the one you have, widening the range you have, and giving you some breathing room (but which also doubles your risk exposure, if the price keeps moving against you...essentially similar to a martingale or double up in gambling). For the Iron Condors, he makes a similar type of adjustment, where you sell off one side and replace it with another side, again giving you breathing room. You sell everything about a week before expiration day. Itis not meant to be a “mechanical” system, and that some subjectivity and educated decision-making is involved in placing the trades, and he admits that this is a skill, or an art, not a science, and that it can take a while to learn how to determine when and where to make these adjustments to manage the trades.

    He also claims that this method does not “pick price direction”, but I disagree somewhat...as there are three directions, up, down, and sideways, it is just that he is teaching you to determine how wide the sideways channel will go. You are making an educated guess as to how wide the price fluctuations will be before the option expires.

    All of this makes sense to me, on the surface, but something tells me it cant be “that easy”. I guess what I am asking is, is this person selling me a “rookie system”, a system that everyone has already heard of and knows that it does not work? Or, does this sound like a valid strategy that can be profitable over the long term? He claims in his training videos that many of his students who take this very seriously, and who continue to study the markets etc, are making considerably large incomes from his particular methods that he is teaching.

    Many thanks for any input you may have!

  • On 01/28, Marc said:

    Hello Christian,

    I have that guy’s course. It is a very good course. It is not as easy as he claims. Like I said to the author of this thread, you can get hurt very badly in a strongly trending market. Sure, you can roll down/up, overlay, etc, but often to not take in losses from your getting out of a bad side, you need to increase shares going back-in when you are sliding more up or down. You mentioned doubling-down; it is kinda like that.

    The big thing with these trades is that you get a small amount for the amount of money you are risking. The allure is that they are usually very high-probability trades, and you are given $ up front.

    Any form of credit up front trades can work very well in the right market conditions. For instance, condors work best in a high IV, sideways market. I used to do many of these on the SP futures options. You smile every month...but when the market starts trending hard, you can get very stressed. You see your one side getting “hit” explode in premium, exactly what you DON’T want once you are in the trade. And so you adjust, but this means you are either going further out in time to gain the same premium, or you are increasing the amount of contracts for your side of the credit spread getting hit, to make the same premium. If the market keeps trending in that direction, you are, of course, now even more exposed!

    So, it really depends on the market condition! When you think of it, condors are decent to do even if the market is trending up decently...Why? Because the IV is FALLING as the market goes up. This is what you want! Yes, you can roll-up, and even though you are exposing yourself more (with either more time, or more contracts to gain the same amount of premium), you at least have the helpful falling IV helping you.

    Every options play has its day in the sun. I know folks who got wiped out doing condors, and others who got badly hurt. Yes, they rolled, and rolled...further hurting themselves when the market tumbled…

    I am intrigued by the double-condor. I am modeling them using the fantastic OptionVue 6 software, and they don’t really look that impressive. Perhaps others can give insight into their merits; at the moment, they visually do not look that appealing.

    Regards,

    Marc

  • On 02/02, Jeffrey said:

    While trading credit spreads, I have found that although about 80% of my trades are winners, the losses I incur when the stock goes against me cancel out the gains from my winning trades.  When the stock goes against me, the spread increases in value pretty quickly, which results in a hefty loss when I have to buy it back.  How can I curtail these losses?  Do I simply close the position earlier?

  • On 02/03, Pete Stolcers said:

    That is a common problem. Look for situations where there is heavy support (for put credit spreads) and sell puts below that level. Those buyers will step in when the stock drops and it will provide an added cushion. By the same token, when the stock breaks below that level, you know you have to get out. Also avoid stocks that have made a big run in recent weeks to new highs. Those stocks are vulnerable to a big pullback.

  • On 02/10, sanjeev said:

    hi pete,

    i have benefited a lot from insights in all of your articles. so i want to say thank you!

    if possible, could you please share thoughts on

    1) how to get a good fill on vertical spreads. mine dont seem to fill easily. if i enter an order, then cancel if it does not fill in 1-2 minutes, then how long should i wait to enter the order again. should i leg in or give up edge. i dont know how the MM algorithms work.

    2) i have read that it is wise to close the spread if i have already reached say 80% of the possible profit. that way, i can take advantage of stock trading range, and can hopefully, repeat the same spread trade many times. what do you believe about whether spread should be held till expiry (to get max profit and not pay commission), or should i exit and take profits when i can make xx% profit target.

    thanks again!

  • On 02/11, Pete Stolcers said:

    1. I don’t suggest legging in. Ideally, your broker will let you preference the exchange. What one Market Maker won’t fill, another might. If you must go to one exchange, wait about 4-5 minutes before re-entering it. You don’t want to seem too anxious. The main thing is that they know the order is dynamic and they can’t just lean on it. If it is of interest to them, they need to act on it or it will get pulled.

    2. It depends. If there is news pending (like earnings), buy it back. I reeled in a PNRA call credit spread this week and the stock is up $17! That was a wise move. If there is no news pending and I do not need the margin for a new trade, I will let it expire. I don’t like wasting money by buying back worthless options.

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