(Editors Note. We would like to welcome Dan Keegan as a contributor to the CBOE. Dan is a well known and experienced trader. Dan started as a runner at the CBOE in 1978, moving up to act as a Floor Broker for 5 years and then a Market Maker for 17 years. He does mentoring for investors and sends out a weekly newsletter to subscribers. His web-site is optionauthority.com. Welcome Dan!)
Selling credit spreads is a very popular starting point for many retail options traders. A call credit spread is a bearish trade and a put credit spread is a bullish trade. Both of them involve selling an option with a higher premium and buying an option with a lower premium. But many investors only look at credit spreads. We'll show two credit spread examples but compare them to debit spreads.
Let’s look at a call credit spread first. Apple Computer (AAPL) is trading at $130.15. You can sell the July 135 (all regular expiration, July 17th, and transaction costs not included) call at $2.43. In order to define your risk you buy the July 140 call at $1.13, thereby creating a credit of $1.30. The maximum value for a vertical call spread is the difference between the two strike prices, in this case $5.00.
The maximum profit is $1.30 With AAPL at $135 or lower, where both options are out-of-the money (OTM). The maximum loss is $3.70 with AAPL at $140 or higher. The breakeven point occurs at $136.30. Losses rise with AAPL between $136.30 and $140, capping out at a loss of $3.70. The July 140-145 call spread can be sold for a credit of $0.62. That would bring in less than half of the credit of the July 135-140 call spread but with much less chance of the short call becoming in-the money (ITM).
An alternative to the AAPL 135 -140 call credit spread for a $1.30 credit is the AAPL July 140-135 put debit spread for $3.70. You can buy the July 140 puts for $10.90 and sell the 135 strike puts for $7.20. The maximum profit is $1.30 with AAPL at 135 or lower. The maximum loss is $3.70 at 140 or higher. The breakeven point is $136.30. If you could buy the put spread for $3.65 versus selling the call spread at $1.30 then you choose the debit spread due to a $0.05 advantage. The credit spread and debit spread show an almost identical risk / reward.
Now let’s look at a put credit spread. Facebook (symbol FB) is trading at $81.01. You can sell the July 77.50 put at $1.35. To quantify your risk, buy the July 72.50 strike put at $0.45, thereby creating a credit of 0.90. The maximum value for a vertical put spread is also the difference between the two strike prices, in this case $5.00. The maximum profit is $0.90 with FB $77.50 or higher, where both options are out-of-the money (OTM). The maximum loss is $4.10 with FB $72.50 or lower. The breakeven point occurs at $76.60 ($77.50 less $0.90 credit). Losses rise as FB drops below $76.60 all the way to $72.50, capping out at $4.10. The FB July 67.50 - 72.50 put spread can be sold for a credit of $0.33. That would bring in less than half of the credit of the July 72.50 - 77.50 put spread but with much less chance of the short put becoming ITM.
An alternative to the FB July 72.50 - 77.50 put credit spread for $0.90, is the July 77.50 - 72.50 call debit spread for $4.10. You can buy the July 77.50 calls for $9.20 and sell the 72.50 calls for $5.10. The maximum profit is $0.90 with FB $77.50 or higher. The maximum loss is $4.10 at $72.50 or lower. The breakeven point is FB $76.60. If you can buy the call spread for $4.00 versus selling the put spread at $0.90 then you choose the debit spread due to a $0.10 advantage.
The common mis-perception for rookie traders is to trade a credit spread because credit spreads “make money.” For example the FB 72.50 - 77.50 put spread brings in a $0.90 credit. Actually, you only make money when the spread trades lower than $0.90. If it’s trading at $0.80 you’re up $0.10. If it’s trading at $1.00 you’re down $0.10. A credit spread is only superior to a debit spread if it conveys some sort of advantage. Both the AAPL and FB positions show the debit spread could show a slightly better risk / reward than the credit spread.
So with some experience trading spreads, it will only take a few more seconds to compare a debit spread to the credit spread you're looking at. In most cases they will be similar, but occasionally one might by at a slight advantage over the other.