Option spreads are useful strategies that traders can use to risk less capital while maintaining leveraged exposure to stocks.
There are different types of spreads, but today we are going to talk about the two types of vertical spreads: credit and debit spreads.
What are vertical spreads? What are credit and debit spreads?
Vertical spreads is an option strategy that involves purchase an option and sale another option with the same expiration date, on the same stock. When you use two different options in the same strategy, they are called “legs”.
By buying an option, you gain leveraged exposure to an underlying asset, roughly equivalent to the amount of delta in the option multiplied by 100. 50 delta? This option has leverage roughly equivalent to 50 shares of the stock. By selling an option, you reduce the cost of the premium associated with buying an option. However, your delta also changes and your maximum profit is capped when you exercise your short option.
When you buy (long) a vertical spread is a debit spread. When you sell (short) a vertical spread is a credit spread.
To initiate a spread, you would buy an option closer to the money while selling another option (with the same expiration date) further out of the money. To initiate a credit spread, you would do the opposite: buy one option further out of the money while selling another option closer to the money.
You can make bullish and bearish bets with debit and credit spreads. To make a bullish bet, you can either sell a credit spread put or buy a debit spread call. To make a bearish bet, you can either sell a call credit spread or buy a put debit spread.
How to calculate the maximum value and maximum risk of a vertical spread
It is easy to calculate the maximum value of a vertical spread. You simply subtract the two strike prices from each other and multiply by 100 (remember that options are contracts that represent 100 shares of an asset). For example, if you have a vertical split of 100/90, the maximum value is $1,000.
To calculate the maximum risk (or cost) of a vertical spread, simply subtract the premium (price) of your long option from the premium (price) of your short option.
Is it a positive Number? Congratulations, you are now the proud owner of a debit spread, and positive the number is the amount of premium (debit) you need to risk to use the strategy.
Is it a negative Number? So it’s a credit spread, and this negative number is the maximum profit (or credit) you can earn if the strategy goes your way. In the case of a credit spread, you must allow the brokerage to retain collateral – which is the maximum amount you can potentially lose in the trade.
It is important to note that credit and debit spreads carry defined risk. This means that you cannot lose more than you initially risk by adopting either strategy. In other words, your maximum risk is what you paid.
Are all the numbers getting confused? Let’s take a concrete example.
Concrete example of a credit and debit spread: Adobe (ADBE)
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In the example above, we are looking at a real options chain from June 16, 2022 in Adobe (ADBE) – Get the report from Adobe Inc.. Notably, it is a day before profits, and due to the high IV associated with profit events, these options are looking dear. This looks like a great opportunity to limit our maximum risk with a vertical spread.
Let’s say we want to make a bearish prediction: Adobe (ADBE) will fall to at least $355 by June 17th. (which by the way, it made.) What would be the best strategy to use: a sell debit spread or a buy credit spread?
The easiest way is to let volatility decide. If you think implied volatility is high and about to fall, you should arm yourself with a credit spread, because credit spreads are vega negative. This means that they should benefit from lower volatility.
If you think otherwise – that the IV is too low and will increase, you should opt for a debit spread. They are vega positive, meaning they benefit from increased volatility.
So, to answer the question from earlier: with the IV high, profits coming in, and the tied IV crashing, the right choice in this situation is probably a credit spread.
In this case, you can do it by purchase the out-of-play $370 strike call (at an average price of $11.40), and sale the $355 in-the-money strike call ($19.80). $11.40 subtracted from $19.80 = -$7.40, which is the maximum profit (or credit) associated with this trade. The maximum risk (guarantee) is $7.60 and your break-even point is $362.40.
Vocabulary check: Break even — The stock price a trade must reach for the trader to “recoup” what he initially risked.
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Call Credit Spreads vs. Long Puts: Pros and Cons
Compare the $370/$355 call credit spread to the $370 long put in Adobe’s options chain.
A big difference between these two trades is the break-even point. In the example above, the $370 bet costs the trader 15.63 (using the average price, rounded to half a cent). This means that the breakeven point is $354.37. Compare this to the $370/$355 call credit spread breakeven point we constructed above, which carries a breakeven point of $362.40. That’s a difference of two percentage points. Because the breakeven point of the credit spread is closer to the currency, it is easier for this trade to become profitable.
And in the case of Adobe, which fell to around $355 at expiry, we know in hindsight that the credit spread would have been a much more effective tool than a long put. The credit spread ended with almost complete profitability, the long put didn’t even break even.
However, imagine that on the expiration date, Adobe (ADBE) had dropped to $300! An unlikely event, but on the eve of a results event, anything is possible. The $370 long put described above would now be worth around $70.00 (an actual amount of $7,000). Conversely, this spread is capped at a maximum value of $15.00 ($1,500), meaning there is no additional credit beyond a stock price of $355 (the short leg). In extreme cases like this, a long sale would take the cake.
Other Credit Spread Use Cases
The above scenario in Adobe examines a situation where options expire in one day. However, many traders use credit spreads for an entirely different purpose: to collect theta decay.
By selling a spread that is already out of the money, you are exposing yourself to positive theta. This means that unlike your standard long call or put (which are theta negative), you benefit from the passage of time. Even if the underlying stock is not moving, your spread is going up in value with every passing moment.
The downside to this strategy is that you often have to risk more in collateral than you can earn in credit. This is because the odds are already in your favor – options (which are out of the money) are more likely to stay MTM.
Other Debit Spread Use Cases
Debit spreads don’t have to be purchased all at once. Rather than buying the whole thing in one clip, you can leg in! Remember that long calls alone will always have a higher delta than their throughput equivalent. A higher delta means faster price movement.
Traders can get the best of both worlds when getting into spreads. To make this move, you must first buy the call leg, and later, once the call is profitable, sell another out-of-the-money call at the same expiration – thus “locking in” part of the profit, while maintaining some post exposure!
This is a popular strategy that Market Rebellion co-founder Jon Najarian uses all the time.
Learning about options can seem overwhelming, but it’s worth it. Every option strategy is like a tool, and the more strategies you master, the bigger your toolbox becomes. While reading this article, you learned strategies that can be used to:
- Lower the cost base of your options trade (albeit with capped potential)
- Lower your break-even point and increase your chances of profitability
- Mitigate or even benefit from time decay
- Lock in profits while maintaining exposure to a position
But your work is not done yet! Go ahead and experiment with these strategies – preferably with paper trading, until you feel comfortable. Not only that, but by learning the ins and outs of these strategies, you’ll build the foundation for learning other more advanced options strategies, like iron condors and more!