Credit Spread vs. Debit Spread: What's the Difference?

Credit Spread vs. Debit Spread: An Overview

Credit spreads and debit spreads are different spread strategies that can be used when investing in options. Both are vertical spreads or positions that are made up entirely of calls or entirely of puts with long and short options at different strikes. They both require buying and selling options (with the same security) with the same expiration date but different strike prices.

Although their structure may seem similar, these two spreads are inherently different. While a credit spread involves the net receipts of premiums, debit spreads involve the net payments of premiums.

Credit Spreads

A credit spread involves selling or writing a high-premium option and simultaneously buying a lower premium option. The premium received from the written option is greater than the premium paid for the long option, resulting in a premium credited into the trader's or investor's account when the position is opened. When traders or investors use a credit spread strategy, the maximum profit they receive is the net premium. The credit spread results in a profit when the spreads narrow.

For example, a trader implements a credit spread strategy by:

• Writing one March call option with a strike price of $30 for $3
• Buying one March call option at a strike price of $40 for $1

These two actions are done simultaneously. Since the usual multiplier on an equity option is 100, the net premium received is $200 for the trade. Furthermore, the trader profits if the strategy narrows.

A bearish trader expects stock prices to decrease. They buy call options (long call) at a certain strike price and sell (short call) the same number of call options within the same class and with the same expiration at a lower strike price. In contrast, bullish traders expect stock prices to rise, and therefore, buy call options at a certain strike price and sell the same number of call options within the same class and with the same expiration at a higher strike price.

But why would a trader use this strategy? It allows them to mitigate their risk if the market moves in the opposite direction and the requirements for margin accounts when using credit spreads tend to be lower than other options. Keep in mind, though, that the long option of the spread minimizes any potential for profits. And commissions tend to be higher since the spread requires two options.

Debit Spreads

A debit spread involves buying an option with a higher premium and simultaneously selling an option with a lower premium, where the premium paid for the long option of the spread is more than the premium received from the written option. This strategy is commonly used by options trading beginners.

Unlike a credit spread, a debit spread results in a premium debited or paid from the trader's or investor's account when the position is opened. Debit spreads are primarily used to offset the costs associated with owning long options positions.

For example, a trader buys one May put option with a strike price of $20 for $5 and simultaneously sells one May put option with a strike price of $10 for $1. Therefore, he paid $4, or $400 for the trade. If the trade is out of the money, his maximum loss is reduced to $400, as opposed to $500 if he only bought the put option.

The use of debit spreads allows traders to limit the total amount of losses to their initial costs. They also allow for a greater return compared to other trading strategies, especially when the market experiences moderate price changes. But traders should know that profits are limited when they use debit spreads because losses are limited.

Key Differences

Now that you know what credit and debit spreads are, here are some of the characteristics that set the two apart.

Premiums

Credit spreads involve net receipts while debit spreads involve net payments. In a credit spread, the trader receives a premium in their account when they write (sell) an option with a higher premium while buying an option with a lower premium.

Debit spreads, on the other hand, are the opposite: they involve buying options with a higher premium and selling those with lower premiums. The premium paid for the long option is higher than the one received for the written option.

Trading Environments

Credit spreads can be used in different trading environments. This means traders can execute them during periods of high and low implied volatility. Investors need to increase their positions when things get risky and lower their positions when market volatility is lower.

Debit spreads, on the other hand, are generally meant for environments with low implied volatility. But there are certain thresholds that traders may use for each: an implied volatility percentile above 50% for credit spreads and a percentile below 50% for debit spreads.

Other Differences

Some of the other major differences between credit and debit spreads include:

• Potential for Loss: With a credit spread, the loss potential may be higher than the initial premium collected while the loss potential is limited to the net payment premium paid for debit spreads.
• Use of Margin: Credit spreads normally require the use of margin in order to trade while debit spreads don't.
• Time Decay: Investors who trade using credit spreads benefit from time decay. This is the rate of decline in the value of an option with the passage of time. It is the opposite for debit spreads, where time works against the investor.

The Bottom Line

Savvy options investors can incorporate different strategies, such as credit and debit spreads, into their trading routines. Traders who use credit spreads are focused on net receipts of premiums (selling or writing a high-premium option while buying one with a lower premium). Those who use debit spreads are focused on net payments of premiums (buying an option with a higher premium while selling an option with a lower premium).

Just like other options strategies, these trading tools may seem complicated at first. But once you nail down the basics, you may find them easy to employ. It just takes some time to develop an understanding of when to employ them and how to execute them. If you're starting out though, it's always a good idea to do your research and, if you need to, consult a professional for advice to minimize your losses.