Vertical spreads are one of the most common strategies in options trading. They generally consist of a bull spread and a bear spread, with both having different strike prices but the same expiration date. The two vertical spreads that I will detail today are the “credit”, and “debit” vertically spreads.
Before going into what exactly these two types of vertical spreads mean, let’s first discuss credit spreads. A credit spread is a strategy in which you buy an option at one strike price and sell another option at a higher price. In other words, you make money if your short position increases in value more than your prolonged position decrease in value from the time you opened them until they expire (or close earlier due to risk management).
As a general example, let’s say you buy a call option with a strike price of $100 and sell a call option for a higher price of $120. Why would someone do this? Well, the reason is that they believe the stock will not go up as high as $120 or won’t continue to move at all before the expiration date of your options.
In either case, they figured the more likely outcome is that their short position will be worth more than their long position within those two weeks; thus, allowing them to make money off of the difference between these two values (in this case: $20).
Credit spreads can also be referred to as non-directional strategies because they don’t require your prediction to be correct for you to make money. It also means that you lose more than what you initially invested if the stock goes down. These are generally used by less experienced or beginning traders because their risk is much lower than other non-directional strategies such as the calendar spread.
Now, let’s compare this with a debit spread where instead of selling an option at a higher price and buying one at a lower price, we do it the exact opposite way – buy high sell low. The difference here is that instead of making money off the value between two positions, your profit comes from how much premium decay affects both positions over time.
If our previous example were trading Apple (AAPL) stock options with a debit spread, we would have bought a call option for $100 and sold a call option for a lower price of $80. We would have initially invested less money than the credit spread example, but our risk is much higher.
While both trades would expire simultaneously, since we had more invested in this position (in this case: 20%) than the previous one (in this case: 10%), there’s not as much room for error as there was before.
Debit spreads can be used by experienced traders who are more concerned about minimizing their risk than maximizing their profit, especially those who trade weekly options. Also, these types of strategies tend to be utilized on stocks that experience very little volatility with minimal time decay.
The main difference between vertical and credit spreads is that the former uses both long and short positions, whereas the latter only does one or the other simultaneously. Debit spreads, on the other hand, use only short positions. Credit spreads are riskier but have lower commissions charges to compensate for this increase in risk.
Debit spreads are safer than credit spreads but have higher commissions charges to account for their decrease in risk. Generally, beginning traders should use credit spread strategies since they’re much less risky than debit spreads.
However, those with more experience may find it worthwhile to invest in debit spreads instead so as not to limit their range of possible investments too much by being restricted to only the safest option(check out Saxo for more info).