Credit and Debit Spreads Explained

Credit and debit spreads are two fantastic options trading strategies. The credit and debit spread is a great way to reduce your risk while trading the stock market. Credit spreads are a selling strategy that is less directional based than debit spreads whereas you could make money if the stock trades sideways. Debit spreads are a directional based strategy that needs to move in a direction in order to profit.

Options trading gives the right but not the obligation to buy (call) or sell (put) a stock at a specified price.

As you learn how to invest in the stock market with little money options become highly attractive. One options contract controls 100 shares of a stock. In essence, you’re spending less to control more.

However, there are more moving parts to options than stocks. For example, time decay and implied volatility.

Credit and Debit Spreads

Credit and debit spreads are just a couple of the different strategies for options trading. One of the biggest draws to spreads is the ability to make money in any market.

The market moves up, down and sideways. As a result, you want to be able to make money even when it’s neutral. Hence where options trading comes in. Spreads were designed to limit risk as wells as make money in any market.

Trading options for a living works when your risk is limited. Another attractive quality of credit and debit spreads is the fact that they’re less expensive to purchase.

As a result, not only are you limiting your risk, you’re also spending less money to place the trade. The only drawback however, is the cap on profit potential. Although, protecting your account is better than going for the home run every time.

Since options have more moving parts than stocks, the ability to lose more is very real. So while profit potential may be limited, so is the risk.

In fact, protecting yourself is more important than placing huge trades.  Your trading life will last longer when you protect yourself.

Credit and debit spreads are great for growing small accounts. They manage risk while being inexpensive to execute. While options are considered risky, it’s much less risky than trading penny stocks.

As a result, you’re able to trade the large cap stocks cheaply with spreads.

The Credit Spread

credit and debit spreads

What is a credit spread? It’s made up of two options contracts with the same stock. You purchase one and sell another with the same expiration date but different strike prices.

The credit spread strategy was designed to turn a profit when when the spreads between the two options narrow. A net credit is received when the trade is placed and you want them to expire (narrow) for profit.

Traders are able to use this strategy whether bullish or bearish on a stock. This means that you need to be able to choose the correct direction. If you’re extremely bullish, make sure you have an idea of the time and price it can reach to maximize profit.

If you’re only moderately bullish, set a target price you want the stock to hit. Remember that bullish credit spreads are cheaper but can still expire worthless. In other words, you’ll still lose money but it is cheaper than a naked call.

You can be bearish with credit spreads as well. For example, you can do a bear call spread or bear put spread. Again, it’s cheaper to trade which minimizes risk. Hence why credit and debit spreads are popular among options traders.

The Debit Spread

The debit spread is also made up of two options contracts. However that’s where the similarities end. A debit spread is when you buy an options contract with a higher premium and sell a contact with a lower premium.

Your goal is to have the premiums of the two options spreads widen. It’s known as a debit spread because the money is debited from your account when the trade is placed.

Profit potential is also capped with this strategy. However risk is as well. The risk you incur with this trade happens to be the amount debited from your account. You can’t lose more than that.

That can be the appeal of debit spreads. In other words, if you can afford the net debit, you’ve already incurred the risk. The only thing to do from there is profit.

Credit and debit spreads are different. However, both are effective.

Trade the Patterns

credit and debit spreads

With credit and debit spreads you still need to pick a direction. While these strategies are cheaper to execute, you still want to minimize loss as much as possible.

It’s important to remember that no trade will be successful 100% of the time. Even the best traders fail 30-40% of the time. The key to placing smart trades is knowing patterns.

Candlesticks by themselves tell a story. However, grouped together they form patterns. The patterns tell you if a bullish or bearish break is coming as well as support and resistance.

Patterns do break down all the time. Bullish and bearish patterns form within each other all the time causing the breakdown. Three inside up patterns are going to be different than evening star patterns.

Knowing what the patterns look like and mean will determine what kind of credit or debit spread you’re going to buy.

Practice Trading Spreads

Our trading service will always recommend practice trading before going live. Open a paper trading account. We recommend ThinkorSwim.

Our can be apart of our trading rooms while you practice. As a result, you have access to traders from all over who are able to answer questions as well as talk about trades.

If you have access to these tools like rooms and stock watch lists, use them. Practice trading credit and debit spreads using the swing trade watch lists. Practice buying and selling spreads.

You’ll notice that the options chain says vertical spreads. Credit and debit spreads fall under that category. Hence the need to practice. That way you know how everything works.

The Bottom Line on Credit and Debit Spreads

Credit and debit spreads are inexpensive to execute. This, in turn, reduces the risk of your trade. Although profits may be capped, making $100-$400 at a time is going to build your account. Taking profits, no matter how small, keep you from going broke.

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