Debit Spreads Versus Credit Spreads – Part One

Debit Spreads Versus Credit Spreads - Part One

Posted January 12th, 2009 by Josip Causic in Education

Debit Vs Credit Spreads
In this article we will examine a specific case of a debit and a credit spread in order to point out that there is virtually very little difference between the two.

Instead of attempting to explain the concept by using a fictitious example, the stock XYZ with the one strike price being at this level and the other one at that level, etc, we shall utilize a couple of my recent trades for the same purpose. Again, this scrutiny is for education purposes only and it is not intended to be a recommendation of any kind.

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. The Chevron Corporation has passed those minimum requirements.

After knowing WHAT to trade, the issue becomes WHEN to trade it. Figure 1 shows that on 12-04-2008, the CVX was trading slightly above 70 which in the past had acted as a short-term diagonal support.

CLICK HERE FOR THE 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 the Chevron was AT or NEAR its support, I had numerous choices for going long such as:

Buy the underlying
Buy a call
Buy a debit spread, namely a Bull Call, or
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 ROI (Return on the Investment) of 37% while my Bull Call was 36%. Not even once did I consider going long with the b possibility, a straight directional call.

In my previous articles, I have encouraged traders to become premium sellers. This trade is not an exception to my teaching. Out of the a-b-c-d choices presented above, I selected first a Bull Call (choice C) and then a Bull Put strategy (choice D).

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 for December 65 call 9.52 which would be for one contract $952.00 plus the commission.

Instead I simultaneously bought Dec 65c @ 9.52 and sold December 70 call for 5.82 which in turn reduced my entry price to 3.70 or $370.00 per contract plus the two entry commissions.