When trading in options there are a ton of different strategies that traders can employ and these strategies have various classifications. One such classification is the credit spread versus debit spread option trading strategy. In today’s podcast we are going to define and understand the credit spread option trading strategy. We are also going to differentiate credit spread option trading from its counterpart, debit spread option trading so as to get a clear differentiation between the two.
Are you ready? Let’s jump right into it!
In credit spread option trading, the trader sells a high surcharge option and at the same time buys a low surcharge option. By doing this, and by the difference between the two premiums, aka surcharges of the two option contracts, a premium is credited to the trader’s account when he opens his positions.
Both types of options spread trading strategies involve buying and selling options related to the same underlying asset. While credit spread involves selling a high option premium and simultaneously buying a low premium option, debit spread involves buying a high premium option and selling a low premium option, resulting in a debit from the trader’s account when he opens his positions.
In credit spread option trading, the focus is on earning through this difference in the premiums of the bought and sold options. It is preferred by more experienced hands as compared to its counterpart which is sought after by beginners.
To get a clear picture of the concept, we could compare Options Spread trading strategies to the whole concept of people donating so as to enjoy goodwill from the universe or creator. People sort of believe they’ve earned brownie points by their donation and that their gesture of generosity will serve to help them keep earning well in the future. So, in other words they believe that their donation buys them future earnings. The difference between what they earn and what they donate in any case, is fairly high. They keep earning and keep donating and there continues to be a sizable difference between the amount donated and the amount earned. The donation can be compared to the lower premium option that is sold while the earnings can be compared to the higher premium option purchased by the trader. The difference between the earnings and the donation can be compared to the premium that is credited to the trader’s account when he opens his positions.
Let us look at a real life example of Credit Spread options trading. Ram sells a call option for December 2020 with a strike price of Rs 3,000 and a premium of Rs 500. Simultaneously, he sells a call option for December 2020 with a strike price of Rs 3,500 and a premium of Rs 430. Assuming the multiplier is 100, the trader will earn Rs 70 x 100 = Rs 7,000 as net premium.
A little while ago we differentiated between credit spread and debit spread trading strategies. You’re probably wondering why someone would opt for a debit from their account if there is a similar option that allows for a credit into their account. And that’s a very good question. The explanation is that each strategy helps meet a unique goal. As mentioned, credit spread option trading is pursued by traders who want to earn on the difference between premiums.
On the other hand, debit spread option trading is simply used by traders to reduce their risk on the overall trade.
Let’s also look at an example of debit spread option trading: A trader buys a January 2021 call option with a strike price of Rs 5,000 and a premium of Rs 500. Simultaneously he sells a call option with a strike price of Rs 4,000 and a premium of Rs 400. In case the market price ends up lower than the strike price and the contract is not honoured, then his loss is limited to Rs 100 instead of him risking Rs 500. Assuming a multiplier of 100, his losses are restricted to Rs 10,000 versus Rs 50,000.
Bullish and bearish traders will obviously play the credit spread options trading strategy according to their bullish-bearish tendencies. Bullish traders typically expect the prices to rise. So a bullish trader will buy call options at whatever strike price and then sell the same number of call options (for the same type of asset and with the same expiration) with a higher strike price.
A bearish trader typically expects prices to fall and as a result, he will take long positions on call options at a certain strike price and then take short positions (for the same asset, with the same expiration) with a lower strike price.
A put credit spread involves buying a put option with a certain premium while simultaneously selling a put option with a higher premium. Bull Put Spread is another term used for a put credit spread.
Call credit spread, as you have probably guessed, involves buying a call option with a certain premium while simultaneously selling a call option with a higher premium. Call credit spread is often also referred to as Bear Call spread.
As with all stock market investments, caution is a necessary ingredient when it comes to trading options using the credit spread option trading strategy. Don’t get so carried away with the prospect of having a premium credited to your account that you forget to research the assets that you’re buying or selling options contracts for. Don’t forget there are also costs associated with every transaction or trade. Account for all this when formulating a trading strategy that works for you.