Josip Causic

Debit Spreads vs. Credit Spreads

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Let us combine these two bull calls:

Bull Call Example

I bought to open (BTO) two contracts of Dec 65 Calls at $9.45 (average fill) and sold to open (STO) two contracts of Dec 70 Calls at $5.775 (average fill). My maximum loss was the difference between the premium, which is a debit of $3.675 or $367.50 times two contracts. My maximum profit is the width of spread (strike price 70 minus 65 strike) subtracted from the debit.

Specifically, $5 - $3.675 = $1.325. Therefore, the most I could have made on this trade would have been $132.50 times two contracts. From this amount the two exiting commissions need to be subtracted. To calculate the ROI, we need to divide our max profit of $1.325 with our debit of $3.675, which gives us 36% as our ROI for the bull call spread.

The Bull Put Explanation

Having explained the debit part of the trade, we could turn our attention to the credit part of it. The figure below shows an additional trade, which is in red because it was a sold for the credit.

See full-sized chart.

On the bull put, I had BTO Dec 65 Puts at $1.52 and simultaneously STO Dec 70 Puts at $2.87, receiving the credit in the difference of those two premiums ($2.87 - $1.52 = $1.35), which is $135 for one contract. Once again, the spread's width of $5 - $1.35 (our max profit) would give us $3.65 as our max loss. The ROI is $1.35 (max profit) divided by $3.65 (max loss), which comes to 37%. In short, the ROI on the bull put is only 1% better than bull call's ROI of 36%.

A brief note: The max profit of $1.325 per contract on the first vertical (bull call) and the max profit of $1.35 on the second vertical (bull put) are just that -- the max profit. The max profits are occasionally achieved if the trader holds the position until the expiry. In my case, the chart determined my exit.

See full-sized chart.

The figure above shows that on Dec. 8, 2008, CVX had approached the $80 area, which in the past has acted as a support. On that day, the old support had acted as a new resistance.

Observe on the chart that CVX traveled almost 10 points within four trading sessions. Both of my vertical trades were bullish trades, and the chart was telling me that it was unable to break the resistance. So, on Dec. 9, 2008, I closed both of my verticals.

See full-sized chart.

The figure above shows that I closed both of the debit spreads for $4.30 each. To recap, I got in at $3.65 and sold it for $4.30, making the difference on the two, which was 62.5 cents per contract. I had two contracts, thus the profit was $125; whereas I sold the bull put at the high price of $1.35 and bought it back at 65 cents, making a 70-cent profit or $70 for the contract.

In both cases I made about half of the maximum profit I may have made if I held it until Dec. 19, 2008, which was the day of expiry.

Just ask yourself: Does it make more sense to close the position that has achieved half of its initial goal in four trading sessions or hold it, risking what is already made?

In my case, the answer was obvious.

In conclusion, in this article I have compared apples with apples. Both the credit and debit spread had four commissions -- two for entry and two for exits. In some cases, the credit spread might not have the exiting commissions, yet in this case I have selected the trades of the same number of commission on the very same underlying.

In short, when zooming in on the specifics there is very little difference between the credit and debit spreads. In both cases I was the seller of the premium, which very much goes along with my belief that one should be trading options with the well-defined risk rather than trading them directionally without any spread strategy.

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