Question: Stock Options Debit Spread Mystery?
Ok I will admit that I am slightly new to Options (been dealing with them for about a year now) but one thing has always perplexed me. Credit Spreads add to my account X credit at experation (ignore commissions for the sake of simplicity). When I put on a Debit trade or spread, X amount of money is subtracted from my account. When I close these trades, I either let them expire profitable or buy back (credit) and sell off (debit) to close early. My question is why would anyone looking to do spreads do a debit spread over a credit spread? You have to pay for it and may not get any of that money back. With a credit spread, you have a margin requirement that you will get back as long as it expires profitable. Is there something I am missing?
This question came to me when I looked at a basic calendar. Ya in the end I am selling off the back month for a reimbursement on some of the debit, but I cant sell it back for what i bought it for a month ago. I ultimately lock myself into a guaranteed negative transaction that takes away from the credit I will receive at the end of the month (assuming the calendar expires profitable).
Any help (links or explanations) to how it ultimately works will help!
Answer:
<<<My question is why would anyone looking to do spreads do a debit spread over a credit spread?>>>
Vertical Spreads:
Assume a Stock is trading at $50 and I do not think the stock price will move significantly before expiration. I also believe implied volatility is too high. To capitalize on the situation I want to open a bullish vertical spread using $45 and $50 strike prices. I can open do this two ways. I can use a put credit spread, selling the $50 put and buying the $45 put, or I can use a call debit spread, selling the $50 call and buying the $45 call. If I sell the put spread, I will receive $2.10 per share when I open the spread. If I buy the call spread, I will pay $2.65 per share when I open the spread.
My maximum profit from the put spread is $2.10 per share.
My maximum loss fron the put spread is $5.00 - $2.10 = $2.90 per share.
My maximum profit from the call spread is $5.00 - $2.65 = $2.35 per share.
My maximum loss from the call spread is $2.35 per share.
I would prefer the call debit spread to the put credit spread in this example. Of course, it is equally possible that I could receive $2.35 for the put credit spread and have to pay $2.90 for the call debit spread, in which case I would prefer the credit spread to the debit spread.
Calendar (horizontal) spread
<<<This question came to me when I looked at a basic calendar. Ya in the end I am selling off the back month for a reimbursement on some of the debit, but I cant sell it back for what i bought it for a month ago.>>>
If you buy a calendar spread when implied volatility is too low there is a good chance that you will be able to sell the back month option for more than you paid for it, possibly giving you a profit on both legs of the spread. Even if both IV and the stock price remain constant until the front month expires the spread should be profitable since theta (time decay) will have had more of an implact on the front month than the back month.
<<<I ultimately lock myself into a guaranteed negative transaction that takes away from the credit I will receive at the end of the month (assuming the calendar expires profitable).>>>
You do not have a guaranteed negative transaction because the back month option can increase in value due to changes in the stock price and the implied volatility.
<<<Is there something I am missing?>>>
One thing you do not seem to be taking into account for either the vertical or calendar spreads is the impact of a change in implied volatility prior to expiration. A change in IV will have a bigger impact on the ATM option (in a vertical spread) and the back month option (in a calendar spread). In a vertical spread you want to buy the ATM option if you think IV is going to increase, and you want to sell the ATM option if you think IV is going to decrease. Similarly, you only want to open a standard calendar spread when you expect IV to increase.
Option trading is more about volatility than the direction the stock price will go. In general it is better to take a stock position (long or short) than an options position unless you think implied volatility is too high or you think implied volatility is too low.
Someone who enters a spread (either debit or credit) should be hoping that the spread will change in their favor (either widen or narrow depending which side of the trade they're on) and the position can be offset at a profit,