Q and A. Credit Spreads vs Debit Spreads

I recently responded to this question on a public forum (EliteTrader:

"Why are vertical debit spreads (bull call & bear put spreads) not discussed much? Instead, it seems that Iron Condors and credit spreads are the preferred topic. When you consider the risk/reward ratio of a debit spread vs. a credit spread, especially if both of which are about 2 or 3 strikes otm, it seems that the preference would be a vertical credit spread because of the risk/reward."

It's true.  Iron condors are a popular strategy and many blogs discuss this strategy (unfortunately including those that want to charge high fees to teach investors how to trade them). 

As far as credit spreads and debit spreads go, the reason both are not discussed equally is there there is no need to do so.  When the underlying asset, the strike prices, and the expiration are identical, then buying the call spread and selling the put spread (both bullish plays) are equivalent.

For example, these trades are equivalent:

        Buy 10 RUT  Mar 490/500 call spreads.  Pay $X
  Sell 10 RUT  Mar 490/500 put spreads.  Collect $10 – X

[If you can collect $4 for the put spread, don't pay more than $6 for the call spread.  In fact, don't pay as much as $6 because you must pay interest on the $600 cash required whereas you could be collecting interest on the $400 cash received.]

By equivalent, I mean that:

The potential profit is equal

The maximum loss is equal

At any RUT price, when the settlement price (RLS) is determined on expiration Friday, the profit or loss from either position is equal to that of the other.
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4 Responses to Q and A. Credit Spreads vs Debit Spreads

  1. Jimmy J. 01/27/2009 at 12:39 PM #

    Mark great blog. I have a question: When you discussed selling covered calls, you said that if the stock starts to fall, to buy back your option to avoid further losses. Is that correct? I gather from that advice that you have already received your premium for the option you have sold. If this is the case, then I believe that I do not have control over the shares I have sold. So how can I buy back if the buyer is in control?
    I would appreciate an answer to this as I want to initiate some small covered calls shortly. Thanks!
    Jimmy

  2. Mark Wolfinger 01/27/2009 at 2:11 PM #

    Jimmy,
    I appreciate the opportunity to help you better understand how to use options. I don’t want to say anything negative, but from the nature of your question I can tell you that you would be better off exercising a little patience. You are not ready to trade options with real money.
    1) When you sell an option, you ALWAYS receive the premium immediately.
    2) I did not tell anyone ‘to’ do what you mentioned. I wrote that this is one way to try to reduce future losses.
    Yes. One method for avoiding further losses involves two steps. If you have losses, it’s safe to assume that the stock price has declined. The first step is to repurchase the option you sold earlier. The second is to write a new option. The point of writing a new option is to collect additional premium, That extra cash provides the cushion that gives you a bit more protection – if the stock falls further. To collect enough extra cash to make this trade reasonable (and collecting 25 cents is NOT enough), you will likely decide to sell a call option with a lower strike price and a more distant expiration. WARNING: DO this only if you still want to own this stock. You are allowed to close the position and take your loss. You are also allowed to do nothing. There are several choices.
    3) “I believe that I do not have control over the shares I have sold”
    a) You sold no shares. You bought the shares.
    b) You sold an option. You can buy back that option at any time before it expires – as long as you have not been assigned an exercise notice.
    Options are fungible. That means each and every XYZ Jun 80 call is interchangeable with each and every other XYX Jun 80 call. Thus, you may buy back the same option you sold earlier. That repurchase cancels any obligation to sell the shares.
    I surely hope this explanation allows you to understand the process.

  3. David 01/27/2009 at 2:26 PM #

    Mark – I am having a heckuva time finding the settlement price of the RUT for January. It’s meaningless at this point since I got out earlier than that, but I am still curious as to what the settlement was as compared to Thursday’s close before expiration. Any help as to where I can find it? I trade on optionsxpress and can’t find it there or at cboe. Thanks.

  4. Mark Wolfinger 01/27/2009 at 2:41 PM #

    The Symbol is RLS.
    NOTE: The days price is usually not available before the markets close for trading on Friday.
    The cboe does provide the data:
    http://www.cboe.com/data/Settlement.aspx
    RLS: Jan 16, 2009: 466.59