Debit Spreads and Credit Spreads: Same Risk, Different Name

Debit Spreads, Credit Spreads Option traders have many terms for what is essentially the same trade. Bull call spreads, for example, are also known as debit call spreads or call verticals. This is confusing enough when it is the just same trade verbalized three different ways. Furthermore, due to put/call parity rules, many entirely different strategies are essentially the same trade (at least from a risk point of view).

Let’s first look at the debit call spread (also known as a bull call spread). For illustrative purposes only, I have chosen to look at an IBM in-the-money 125/130 debit call spread.

We’ll construct the in-the-money (ITM) debit call spread using mid-market levels (as of July 13). The debit required to buy the 125 call and sell the 130 call is $3.40. The maximum gain at expiration is then $1.60 (the difference between the strikes minus the debit paid) and the maximum loss is the $3.40 initially paid.

On the Profit/Loss Calculator, you can see the breakeven for this spread is $128.40 in the stock. Above this level, the spread will be profitable; below, the trade is a loser.

IBM bull call spread

Now look at the out-of-the-money (OTM) credit put spread which is constructed by selling the 130 put and simultaneously buying the 125 put. For this strategy, the seller collects $1.60 upfront, which equals the maximum gain. The maximum loss is the difference between strike prices less that upfront premium ($5.00-$1.60=$3.40). Both spreads are bullish strategies with identical risk/reward characteristics, breakeven, and payoffs. In both strategies, the trader wants the underlying shares to stay higher than $130 to achieve maximum profit and avoid losses.

IBM bull put spread

To summarize:

125/130 bull call spread debit is $3.40
Potential return on risk is $1.60/$3.40 = 47%

130/125 bull put spread credit is $1.60
Potential return on risk is $1.60/$3.40 = 47%

The fact that the spread premiums create precisely the same return is not surprising. They are synthetically equivalent (a property of put/call parity relationships) and thus virtually identical in terms of risk/reward. Traders may be able to work into these spreads for slightly better or worse prices that will affect which one they prefer. Be aware as well that dividends can impact the value of in-the-money calls.

So if the strategies are essentially equivalent, which is what makes synthetic option relationships work, which do you choose? It may simply depend on what type of trader you are. Here are a few reasons different traders choose among equivalent credit or debit strategies:

• For option traders who are only approved for buying spreads, they do not have a choice. Their broker or type of account may not allow any short or credit strategies. This may seem unfair since the strategies are equal, but that’s how options are treated for the security of brokers and inexperienced account holders.

• For active option traders, especially institutional professionals, it comes down to cash management and the efficient use of capital. They are able to sell more OTM spreads and iron condors because they collect premium upfront, have minimal and/or offsetting margin collateral requirements (i.e., portfolio margining), and sometimes can earn meaningful interest on balances. Additionally, professional traders are often trading these synthetically equivalent strategies to offset risk, turning a bullish spread into a “riskless” box trade.

• Psychologically, for traders who think “selling is better,” credit spreads may dominate their strategies. They may prefer selling spreads and profiting with theta and time decay. However this is not a valid theoretical reason! Because these spreads are synthetically equivalent, the theta is the same for both the debit call spread and credit put spread. Many traders are better at visualizing the risk after paying for the spread upfront and having that payment equal the maximum risk exposure.

A final issue affecting all traders to various degrees is commissions from exiting spreads or from exercise and assignment at or before expiration. If you sell the 130/125 bull put spread and it stays out-of-the-money as you had hoped, your options expire worthless with no additional commissions. But if the 125/130 bull call spread stays in-the-money, you will be required to either exit before expiration and pay commission(s) or pay the commissions from exercise and assignment at expiration. At OptionsHouse, this exercise and assignment fee amounts to $5 each leg, so this is a minimal impact.

Good hunting! Finding the best price on the credit or debit spread of your choice can help maximize your returns!

Photo Credit: di_the_huntress

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