Debit vs Credit Vertical Spreads: Weighing Your Options
The choice between debit and credit spreads hinges on multiple factors including your market outlook, risk tolerance, and the premium costs involved.
- Debit spread: In a debit spread like the one illustrated earlier, you're paying an upfront cost to enter the trade. This is suitable when you have a strong conviction about the direction the stock will move, and you're willing to pay for the potential to earn a higher profit. However, the money spent upfront is at risk if the stock doesn’t move as anticipated.
- Credit spread: On the flip side, in a credit spread, you receive a premium upfront. This could be more appealing if you prefer to have a cushion against small adverse moves in the stock price. The premium received upfront is yours to keep, providing a buffer that could potentially offset losses should the stock move against your position. However, the potential earnings are capped at the premium received.
Nomenclature: Decoding the terminology
In the realm of options trading, the terminology often reflects the anticipated market direction or the tools (options) used in crafting the strategy. A bull spread indicates an outlook where the trader expects the market price to rise, while a bear spread represents a perspective where the market price is anticipated to fall. The terms call and put in the naming convention point to the type of options utilized. A call spread involves call options and is often used in a bullish scenario, while a put spread involves put options, typically used in a bearish scenario.
Now, intertwining these terms, a bear credit vertical spread could also be termed a call credit spread as selling a call at a lower strike and buying a call at a higher strike is a strategy anticipating a bearish movement, hence “bear,” and it generates a credit upfront, hence “credit.”
Common strategies stemming from vertical spreads
Vertical spreads serve as the foundational blocks for many other common strategies in options trading. Here are some of them:
- Iron condor:
An iron condor is essentially two vertical spreads (one call spread and one put spread) positioned on either side of the market. It's utilized when you expect the underlying asset to remain within a specific price range.
- Butterfly spread:
A butterfly spread is a combination of a bull spread and a bear spread, both of which are extensions of the vertical spread. It's used when you expect the price of the underlying asset to either rise or fall to a particular level.
- Calendar spread:
While a calendar spread involves options with different expiration dates rather than different strike prices, the concept of buying and selling options simultaneously, as seen in vertical spreads, remains central to this strategy.
- Diagonal spread:
A diagonal spread is a mix of a vertical spread and a calendar spread, involving options with different expiration dates and strike prices. It allows for more flexibility in managing price expectations over time.
- Double diagonal spread:
A double diagonal spread is a calendar spread and an iron condor rolled into one. It is used when you expect the price of the underlying asset to remain within a certain range, but with the flexibility offered by different expiration dates.
Each of these strategies can be tailored to suit varying market conditions and individual risk appetites, offering a rich toolkit for navigating the options market.
Common undefined risk strategies
After delving into vertical spreads, which form the basis of most defined risk strategies, it's time to step into the realm of undefined risk strategies, should your risk appetite permit. These strategies often come with the potential for higher rewards, but also carry the risk of potentially unlimited losses. A classic example of an undefined risk strategy is the strangle.
Strangle: A common undefined risk strategy
Suppose stock XYZ is trading at $50 and you expect it to stay within a range for a while, but you believe there’s a chance it could make a significant move in either direction. To capitalize on this, you:
- Sell a $45 put for $1 (earning a premium, but taking on the risk if the stock drops significantly).
- Sell a $55 call for $1 (earning another premium, but taking on the risk if the stock rises significantly).
You earn $2 per share upfront, which is the most you could earn. However, your losses could be substantial if the stock makes a large move in either direction, and there's no cap on how much you could lose.