Understanding Options (part 3) – Debit and Credit Spreads

This is part three of a multipart series designed to teach you about options and how to trade them.  Previously, I discussed the basics of options and buying puts and calls. This time, we will combine options into what are known as spreads, in an attempt to profit from various stock movement scenarios.

First off, why the term spreads? A spread just means that your one investment is spread out over multiple positions and each of those positions is referred to as a leg. A spread involving two options is referred to as a two-legged spread, three options make a three-legged spread and so on. The different options are traded as one package, this way it\’s much easier to buy and sell them. Instead of placing on order on each option individually and incurring double the commissions, you trade the spread as one instrument. I\’m going to keep it simple and only discuss two-legged spreads for now.

Debit Spread

A debit spread is the combination of option legs that results in a debit. This just means that the option you buy is priced higher than the option you sell, resulting in a net debit. When a debit spread position is taken using calls, the strategy is also referred to as a bull spread. When put options are used, the strategy changes to a bear spread. Lets take a look at an example using an option chain on QQQ (NASDAQ ETF):

The asking price of the call option that we purchase is circled in red and the bid price of the option we sell is circled in green. We will buy the 65 call for 0.94 and sell the 66 call for 0.51, so the total cost in this example is 0.51 – 0.94 = -0.43; meaning that we purchased this option spread for a grand total of $43. In the next image, using put options, the net debit is 0.75 – 1.12 for a total amount paid of $37.

Max Gain/Loss

In both examples our max loss will be the net amount paid, which is $43 for the bull spread or $37 for the bear spread. The max gain will be calculated the same way for each strategy –> the difference between the two strike prices – the net premium paid (66 – 65 – 0.43 = 0.57 for the bull spread and 64 – 63 – 0.37 = 0.63 for the bear spread).

When to Use

The purpose of this trade is very similar to just buying a call or put and betting that the stock price will move in the direction you expect. The only addition is that you are now selling an option that is further from the money than the one you are buying to lower your overall cost. In our example above, if you are bullish and expect the stock price to rise, you would buy the call with a 65 strike price and sell the 66 call. Your spread will be worth money as it crosses above 65 since you have the right to buy at that price, but past 66 your gain is capped because you have the obligation to sell at that price.

On the put side, your expectation is simply the opposite and you are bearish on the stock hoping it will decline in value. Because of your bearish outlook, you buy the 64 put and at the same time, sell the 63 put. In this scenario, you profit as the stock drops below 64 while your gain is capped when it penetrates 63 and goes below.

Credit Spread

Now that we\’ve covered debit spreads, credit spreads should be pretty easy to understand. We will essentially flip the buying and selling prices so that the amount paid for an option is less than the amount received for selling another, resulting in a net credit. Let\’s take a look at the same option chain from above, but with a net credit as the result:

Above, we are selling a 65 call option for 0.92, giving someone else the right to buy QQQ from us at $65.  In the same trade, we are buying the 66 call for 0.53. The amount we receive from this trade is 0.92 – 0.53 = $39.

Taking a look at put options, our net credit is 1.10 – 0.78 = $32, after we buy the 63 put for 0.78 and sell the 64 at 1.10.

Max Loss/Gain

Looking at the call option credit spread, the 65 call is sold giving the other person the right to buy QQQ at $65. If QQQ were to increase to $100, you would have to buy it on the open market and sell the ETF to the other party for $65. Obviously, you would take a massive loss, so to protect yourself, you purchase the 66 calls at 0.53. You\’re now protected in at any price above $66. That being said, your max loss is the difference between the strike prices – the premium received from selling the spread. The max gain will always be the premium received from selling the spread initially.

When to Use

As established before, debit spreads are used to lower the cost you pay to take a speculative position. What about credit spreads then? They intent of this strategy is collect income from selling the call or put and at the same time, protect yourself if the stock/ETF drastically rises or falls.

Vertical and Horizontal Spreads

All of the examples discussed are considered vertical spreads because the strike prices are above or below each other, in a vertical position. Horizontal spreads are traded using the same strike price, but different expirations as time is on a horizontal line. For example, if you purchase a July 65 call and sell an August 65 call, this would be considered a horizontal credit spread. Time has value so the option further away from expiration will be trading at a higher price.

Conclusion

I\’ve only discussed two-legged spreads, but any number of legs can be added in order to produce your desired outcome. As you can imagine, the complexity rises with each leg that\’s added. In each case, I follow a simple rule to determine what my max loss/gain will be. Simply imagine the worst case scenario (stock rising an infinite amount or declining to 0) and then determine what your obligations/rights will be depending on which positions you hold. Many brokerage firms provide calculators that will do this for you as well. If you still have questions about a particular options trade, let me know and I\’d be happy to evaluate it.