Josip Causic

Debit Spreads vs. Credit Spreads

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This article originally appeared on The Options Insider Web site.

In this article, we will examine a specific case of a debit and a credit spread in order to point out that there is very little difference between the two. To explain the concept, I'll utilize actual trades that I made at the end of 2008.

My normal criteria for trading optionable stocks is the liquidity, which is evident in the volume of the underlying, as well as the high open interest and volume on individual strike prices. At the time of these trades, Chevron Corp. (CVX) passed those minimum requirements.

After knowing WHAT to trade, the issue becomes WHEN to trade it. The chart below shows that on Dec. 4, 2008, CVX was trading slightly above $70, which in the past had acted as a short-term diagonal support.

See full-sized chart.

Strategy Selection

After completing my technical analysis, and determining my market posture as well as my directional bias on the stock, I am faced with the strategy selection. According to my rules, I go long at the support. The CVX was not exactly at the support, but it was very close to it.

Timing the entries perfectly is nearly impossible; it is the timing of the exits that is of more essence to me.

While Chevron was at or near its support, I had numerous choices for going long:

1. Buy the underlying
2. Buy a call
3. Buy a debit spread, namely a bull call
4. Sell a credit spread, explicitly a bull put

I worked out the numbers of risk to reward, and they came out very much identical for both the credit and debit spread. My bull put had a return on investment (ROI) of 37%, while my bull call was 36%. Not even once did I consider going long with a straight directional call.

The Bull Call Explanation

By choosing a bull call instead of a directional (non-spread) straight call, I have reduced two things: my exposure and my financial outlay.

However, let us get to the particulars. Had I just purchased a call, I would have paid $9.52 for a CVX Dec 65 Call, which would have been $952 for one contract plus the commission.

Instead, I simultaneously bought Dec 65 Calls at $9.52 and sold the Dec 70 Calls for $5.82, which, in turn, reduced my entry price to $3.70 or $370 per contract plus the two entry commissions.

See full-sized chart.

As the figure above shows, I did this transaction twice and got an even better fill of $3.65 on the second transaction.