And who in the world wouldn’t want to increase their chances of winning, right?
One of the classic kinds is spread betting, which falls into two: credit and debit.
Now, what exactly is the difference between a credit vs debit spread?
Well, the greatest difference lies in the premiums.
Right now, we must only be confusing you all the more. So allow us to walk you through the similarities and differences of credit vs debit spread.
What are Credit Spreads?
Before we dive into the difference between credit and debit spreads, allow us to introduce you to these option bets first.
Credit spreads are an options bet strategy that makes a maximum profit from the net premium. These profits only generate when the spreads narrow.
So how exactly can you do a credit spread?
To make a credit spread, you have to sell or write a high-premium option. Sounds basic, doesn’t it? The catch is that you also have to buy a lower premium option at the same time.
So this selling and buying will have to occur simultaneously for the spread to work.
Doing this will result in a premium being charged to your account the moment the position opens. That’s because the written premium will be greater than the bought premium.
This explains why this option bet is a “credit” spread. Since the premium will be “credited” from the trader’s account and not yours.
How a Credit Spread Works
We understand that all those words may have just confused you even more, so allow us to give you an example.
And don’t feel bad; we honestly felt all fuzzy reading that jargon for the first time too!
Okay, put yourself in the position of a trader making a credit spread. You’ll be implementing this spread strategy by writing and buying options just like we discussed earlier.
Say you wrote one march call option at a strike price of $30 for $3 and bought one march call option at a strike price of $40 for $1.
Since you bought and wrote simultaneously, the net premium that will be received for the trade will double. And to make it even better, you’ll be profiting extra if the strategy narrows.
Traders make use of credit spread strategies to reduce the risks just in case the market goes against their desired direction.
What are Debit Spreads?
Now let’s talk about debit spreads, don’t worry; we’ll get to setting apart the debit spread vs credit spread soon.
These spreads are best for offsetting costs that come with long option position investments. This technique is famous and widely made use of by options trading beginners.
So, how do you use the debit spread strategy?
All you have to do is make a simultaneous selling and buying of options. But the difference here is that the option you’ll be buying is with a higher premium. And the one you’re selling is with a lower premium.
That is what commonly differentiates credit vs debit options.
Now, what does changing the low and high premiums do?
It results in a debited premium. Which means it charges from the trader’s account once the position finally opens.
The key to this strategy is that the premium for the spread’s long option has to be more than the premium received from the sold one.
How a Debit Spread Works
Before we teach you when to use credit spread vs debit spread, let’s walk through one more example.
This time, we’ll discuss your possible losses and gains as well. So make sure to really imagine yourself in the position.
Say that as a trader, you buy one May put option; the strike price is $20, but you only pay $5. And simultaneously, you sell one May put option with a strike price of $10 for only $1.
Let’s weigh our chances. This strategy mitigates your loss to $400. Compare this to the $500 loss you could’ve had if you only bought the put option. You sure did alleviate your risks.
Debit spreads come into play when you seek to limit the total amounts of losses to your initial costs.
But always keep in mind that this strategy limits your profit just as it does your losses. It’s the common “high risk, high reward” situation all over again.
Pros and Cons of Credit vs Debit Spread
To break down the differences between a credit vs debit spread, we’ll introduce you to both their positive and negative sides.
This will help you decide on which spread is best for your budget and plans. Or help you determine whether you should use a credit vs debit spread depending on the situation.
Let’s start with credit spreads, specifically, what they’re good for.
Credit spreads ideally reduce risks; it allows you to play it safe just in case the share price doesn’t follow your desired direction. Credit spreads also has a lower margin requirement in comparison to other options. And, in comparison to debit spreads, credit spreads are very versatile, price and expiration date-wise.
But credit spreads are not all ideal, and it always depends on the circumstance. One credit spread disadvantage is the reduction of profit potential based on the money you spend on the long option leg. Plus, the commission is more than a single uncovered position.
Moving on to debit spreads…
Debit spreads are best for trade planning since you already know your maximum potential loss. You also won’t have to trade on the margin. And, returns are generally higher, even if the price movements are moderate.
However, your profits have limits, and you may lose them if the price moves against your desires. Another disadvantage would be that you need to pay to enter the trade.
These are a couple of things you should consider before using the credit vs debit spread strategies. Always evaluate your changes, your risks, and how much you’re willing to wager.