Debit Spread vs. Credit Spread: What Are the Differences?

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Contributor, Benzinga
April 17, 2023

Buying calls and puts can increase your portfolio’s returns. But if you have traded enough options, you have likely seen a call or put lose significant value in a short amount of time. Debit and credit spreads can lessen the risk of calls or puts losing value, and credit spreads can even benefit from it. Debit Spreads can minimize losses with less capital at risk, and credit spreads sell options with defined risk. Discovering the differences between these spreads can guide your options trading approach.

Debit Spread

Every spread has the same basic setup. A trader simultaneously buys and sells options contracts of the same type on an options trading app. You can buy a call and sell a call for a call debit spread and trade puts if you want to enter a put debit spread. The options contracts you enter each have the same expiration date, but the strike prices impact your potential gain and loss from the position.

For a debit spread, the trader wants to pay a smaller premium. This trader will buy an option that is closer to the money and then sell an option that is further out of the money. For a call debit spread, the trader may buy a call with a $70 strike price and then sell a call with a $75 strike price. The investor pays a premium for initiating this trade.

If the stock’s price increases significantly, the losses from the $75 short call and gains from the $70 long call will cancel each other out after the stock price exceeds $75 per share. The maximum profit of a debit spread is the difference between the spread and the premium. If a trader paid a $1 premium to initiate this trade, the maximum profit is $400 (4 x 100 = 400). The premiums from the short call can offset losses if the stock’s price stays flat or falls below $70 per share.  

When to Use Debit Spreads

Debit spreads are a useful options trading strategy that can help investors minimize their expenses and still make profits. Debit spreads can help investors who believe a stock will trade within a specific range. Selling the further out-of-the-money option makes the breakeven price more attainable. 

Bullish and Bearish Approaches

Traders can use bull call spreads and bear put spreads to make money from their trades. Bull call spreads are like the previous example. A trader with a long $70 call and a short $75 call makes the most money if the stock appreciates. Gains max out when the stock’s price exceeds $75 per share. 

A trader feeling bearish can set up a bear put spread to profit from downward pressure while lowering risk. This trader may buy a put with a $50 strike price and sell a put with a $40 strike price. If the trader pays a $2 premium for both contracts, the max profit is $800. That’s because the spread is $10, and deducting the $2 premium results in $8. Multiply that by 100 to figure out your max gain ($800 in this example). The breakeven is $48 per share. If the sold put generated a 50-cent premium, the breakeven would have been $47.50 if the trader did not create a bear put spread.

Advantages of Debit Spreads

Thinking about trading debit spreads? This options trading strategy provides several advantages:

  • They do not require much capital to initiate.
  • Your losses are limited, which makes risk tolerance more manageable.
  • Selling an option moves the breakeven price closer to the strike price.
  • Traders can get the same price direction positioning for a discount.

Disadvantages of Debit Spreads

Debit spreads have several perks, but like any investment opportunity, they aren’t perfect. Keep these disadvantages in mind before you consider trading debit spreads:

  • Your gains are limited.
  • The long option can expire worthless.
  • The short option’s premium does not completely offset the long option’s premium.

Credit Spread

Credit spreads also involve trading two of the same type of option simultaneously. However, the trader strives to receive a premium for initiating a credit spread instead of ending up paying money at the start of the trade. Credit spreads limit your gains more than debit spreads, but if the stock’s price stays out of the money, you will end up with the maximum gain.

When to Use Credit Spreads

A credit spread is best for options traders who do not believe the stock’s price will move sharply in a way that increases their spread’s value. Options traders who initiate credit spreads want both of their options to expire worthless. 

Bullish and Bearish Approaches 

Traders can initiate two types of credit spreads. For bull put spreads, the trader receives a premium and hopes the stock’s price will increase. Assume a stock trades at $100 per share. A trader may sell a put with a $95 strike price and buy a put with an $85 strike price. For the purposes of this example, this trade provides a net premium of $4. The trader realizes the max profit if the sold put stays out of the money. The net loss is realized if the stock’s price falls below $85. At that point, losses are defined because the puts now cancel each other out.

A bear call spread involves selling a call with a lower strike price and proceeding to buy a call with a higher strike price. You can initiate this trade by selling a call with a $30 strike price and buying a call with a $35 strike price. This position results in a net premium for the trader. If the stock’s price stays below $30 per share, the trader will realize the maximum profit. However, the trader will lose from the position if the stock rises above their breakeven, with a maximum loss above $35 per share.

Advantages of Credit Spreads

Want to get started with credit spreads? These are some of the perks of incorporating credit spreads for your portfolio:

  • You receive an upfront premium.
  • Your losses are limited.
  • You don’t need much capital to get started
  • Can have a higher probability of profit 

Disadvantages of Credit Spreads

Credit spreads aren’t perfect. It’s good to know these disadvantages before trading credit spreads so you can anticipate them:

  • Your gains are limited. 
  • Your short option may get assigned if in the money
  • The long option’s premium cuts into your profit.

Growing Your Portfolio with Spreads

Debit and credit spreads let options traders take smaller risks. Gains and losses are both capped and can make it easier for options traders to use less capital. Credit spreads can provide income generation in your portfolio. Debit spreads let you enter the same positions for discounts while limiting your upside. Options trading can get complicated, but you can use an easier method to trade options if you are just getting started.

Frequently Asked Questions

Q

Are credit spreads riskier than debit spreads?

A

Both spreads are risky, but neither is riskier than the other. Both spreads let traders limit their gains and losses.

Q

Is a debit spread bullish or bearish?

A

That depends on the debit spread. A debit spread with calls is bullish, while a debit spread with puts is bearish.

Q

What happens if you don't close the debit spread?

A

An out-of-the-money spread will expire worthless and no longer show up on your account. You will have to exercise an in the money option if you do not close it, such as buying 100 shares of a stock if it exceeds the call’s strike price. If you do not have enough funds to exercise the contract, the broker may attempt to close the spread for you so you can realize profits. Otherwise, it will expire unexercised and worthless.