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Spreads Strategy Q&A

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Hi,

I just started reading the MCM and I noticed you offer just one type of vertical spread - the credit spread. This seems to limit your possibility of finding good directional positions and isn't the risk the same in a debit spread anyway? Why wouldn't I do a bullish spread with calls instead of puts? They are the same basic strategy, correct?

Thanks for the info.

WR

Regarding spreads, your comments are correct:

There are two types of vertical (price) spreads -- credit and debit.

Credit Spreads: The bear-call (bearish) and the bull-put (bullish)

Debit Spreads: The bull-call (bullish) and the bear-put (bearish)

Both debit and credit spreads have the same risk-reward outlook.

One advantage of credit spreads is they can be funded with portfolio collateral (eg: stocks on margin) while debit spreads need an investment of actual cash. In addition, credit spreads have lower commission costs because both options (in a successful position) are simply allowed to expire. However, some traders favor positions that have no margin requirement and that's why debit spreads are popular. The primary disadvantage to in-the-money debit spreads (which are equivalent to out-of-the-money credit spreads) is the potential profits are slightly lower at the same cost basis, due to the characteristics of option pricing. For example, it is rare to find an in-the-money put debit spread that will provide the same risk to profit ratio as the equivalent out-of-the-money call credit spread. The same situation exists with in-the-money call debit spreads and out-of-the-money" put credit spreads. The reason is that in-the-money options have very little extrinsic value (premium), when compared to out-of-the-money options, which are generally all premium, and also because the bid/ask spreads are larger, which means you pay more money for long options and sell short options for less money.

The moral of the story? Traders who favor low risk/high probability (vertical) spread strategies will almost always find better profit potential in OTM credit spreads than in the equivalent debit spreads.

MCM Staff

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