The Interrelations of Credit Spreads and Debit Spreads

Many traders I know specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’s because they have become comfortable and don’t have the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads.

Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing.Conventionally, credit-spread traders have the goal of generating income.The short option is usually ATM or OTM. The long option is more OTM.

The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just outof-the-money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread.

With either spread, movement in the underlying may be required,depending on the relationship of the underlying price to the strike prices of the options. And certainly, with a credit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay.

For many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such a way that the maximum loss is required to be deposited to hold the position (this assumes Regulation T margining).

For all intents and purposes, this can turn the trader’s cash position from a credit into a debit. From a cash perspective, all vertical spreads are spreads that require a debit under these margin requirements.Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules.Although margin is an important concern, what we really care about as traders is risk versus reward.

A credit call spread and a debit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity.Building a Box:Two traders, Sam and Isabel, share a joint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share.

Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period.Sam decides to buy the January 62.50 265 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM.

His maximum gain is 1.22,realized if Johnson & Johnson is above $65 (6562.501.28). With Johnson & Johnson at $63.35, Sam’s delta is long 0.29 and his other greeks are about flat.Isabel decides to buy the January 62.5065 put spread for a debit of 1.22. Isabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 a share at expiration, leaving both puts OTM.

Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has a delta that is short around 0.27 and is nearly flat gamma, theta, and vega.Collectively, if both Sam and Isabel hold their trades until expiration, it’s a zero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits.

She cancels out Sam’s loss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’s gains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw.These two spreads were bought for a combined total of 2.50. The collective position, composed of the four legs of these two spreads, forms a new strategy altogether.