Let’s say for instance you have targeted a stock or ETF setup you like and want to make a directional trade.
Maybe some technical indicator alerted you to a possible turn in the underlying or you just needed to hedge your portfolio with a new trade.
Whatever the case, you are now left wondering why type of options strategy to pick.
How do you decide between trading debit spreads vs. credit spreads and when should you use each style?
From our friends at OptionAlpha here are different market environments and setups that might work best for each.
- Debit spreads are directional options buying strategies where you are net paying for an options spread.
- For example:
- Buying a put debit spread would be a directionally bearish position — buying a put option and then selling a put option at a lower strike price.
- Buying a call debit spread, which is a directionally bullish position — buying a call and then selling a call at a higher price.
- For most debit spreads, you want to enter during lower IV environments, generally.
- When entering a position where you are net buying options, you want to do so when implied volatility is super low – ex: IV rank of under 20.
- When IV rank is very low and you enter a debit spread, one way to profit from that is if IV potentially increases.
- With debit spreads, you are also more directional with your assumptions; stock will either turn around or continue in the same direction.
- The underlying foundation with debit spreads is that you want the stock to move.
- Debit spreads can also be used for hedging purposes because it offers quick exposure in one direction or another.
Example: If you have several positions that are becoming too bearish and need some bullish exposure, you can buy a call debit spread, which effectively will give you exposure as soon as the market continues to move higher without experiencing lag time.
You are generally buying these spreads around at the money strikes so as soon as the stock starts moving higher, you have immediate exposure towards that stock going higher.
- Credit spreads are a net selling strategy where you traditionally sell a spread out of the money.
- This gives you a high probability of success, but you are also potentially taking in a lower premium.
- Ex: If the stock is trading at $100, you can sell the 105 call and buy the 110 call.
Credit spreads are great in all environments:
- Just because debit spreads work great in low IV environments, does not mean you should use them over credit spreads.
- Even though IV can be low, that does not mean that the over-expectation of IV pricing, or IV edge, that you gain selling options disappears – it just gets reduced.
- So potential profit with expected returns is much smaller in low IV environments.
- Therefore, you can still trade credit spreads and sell options during low volatility markets you just want to scale back your position size.
- When IV is high, scale up and allocate more towards the trade. When IV is low, scale back the position size.
- Credit spreads are less directional in nature than debit spreads.
- However, you can set up a credit spread to be bullish or bearish.
- But with a credit spread, you still have the potential to make money even if the stock stays the same or goes lower.
Example: If the stock is trading at $100 and you sell the 95 put and buy the 90 put, the stock can stay at 100 and you make money.
It can go down to 97 and you still make money. Or it can go up and you can make money.
Therefore, it has less directional risk for an options trader as opposed to a debit spread. However, because you have less directional risk you take in less money.
Ultimately credit spreads will pay more money, have lower drawdowns, and higher expected returns.
- Credit spreads are income-driven and react slower to the underlying market movements.
- With credit spreads, since you are selling options and your income is capped, it’s generally slower to react to the market movement because it’s an out of the money option.
- Therefore, you do not necessarily realize the profits until much later in the expiration period.
- Where you end up choosing strike prices matters a lot in both credit and debit spreads — based on time and IV levels.
— The Option Specialist