What Are Credit and Debit Spreads in Futures Options
As a broker, I frequently get the question, “Why?” after showing a client a futures option spread. Instead of buying or selling an option outright, traders want to know why they should enter an option spread. The rationale behind entering an option spread will be clarified by this article.
Trading Options Spreads
Compared to buying options outright, buying option spreads allows one to participate in markets at a lower cost. Selling an option to assist pay for the purchase of another option is how this is accomplished. We call this a debit spread. Another way to get a premium without having to sell a naked option, which entails infinite risk, is by using option spreads. To lower risk, this is accomplished by first selling an option and then buying an out-of-the-money option. We call this a credit spread. Let’s examine debit and credit spreads in greater detail.
Debit Spreads
When a trader buys an option spread and the premium is taken out of their account, this is known as a debit spread. This is similar to when you pay for gas with your debit card at the gas station and your bank account is charged. Compared to buying an outright option, debit spreads provide a way to participate in the option market at a lower premium. Let’s say it would cost $3,160 for a trader to buy an at-the-money gold call for September. A trader may not want to invest this much to participate in an option. To cut costs, the trader can employ a bull call debit spread if he has a prediction about where the underlying market will be at expiration. He can buy the 1615/1650 September gold call debit spread for $1,460 if he believes the price of the underlying futures will be at 1650 when it expires. The $1,460 paid for the spread represents the trade’s maximum risk. Therefore, the difference between the strike prices and the spread’s cost, or $2,040, will be the maximum profit.
Credit Spreads
A credit spread is ideal if you believe that the market will not move.n. Suppose a trader believes that the price of maize won’t fall below $6.50/bu. At $6.50, he could sell a naked put option, but the risk is infinite. In terms of account values, selling naked options has been described as “taking the stairs up and the elevator down” in terms of risk and profit. Credit spreads allow you to play where you believe the market won’t go while offering a defined risk. To lower risk, the trader can purchase the 6.00 put for $900 and sell the December 6.50 put for $1800. For the position, the trader would then get $900. The change in strike prices less the premium received, or $1600, represents the maximum risk. The trader will retain the initial premium if the futures price at expiration is higher than $6.50/bu.
Conclusion
Credit and debit spreads in futures options provide traders with cost-effective and risk-managed strategies compared to outright option buying or selling. Debit spreads offer a lower-cost entry into the market with defined risk and profit potential, while credit spreads allow traders to profit from stable markets with limited downside risk.