Credit spreads options strategy involves premium receipts, whereas debit spreads comprises of premium payments. The former involves selling high payment option and concurrently buying low payment option. The payment received gets credited into your account, when position opens.
Concept of credit spreads
The cash in your account has increased but there is also a margin requirement set aside by broker to cover your trade risk. Traders term this as a ‘sub-account’. Let’s understand the concept of credit spreads with an example.
- You opened an account with cash amount of $8
- You gain ‘Option Buying Power’ or OBP of spending $8000 without any risk. [you can even withdraw this entire amount]
- Your broker gives you a chance to invest in stock with 50% margin, means you can buy stock of $16000
To create income, you sell $6 long put OTM for credit spread of $1. The credit is assumed to be put into your account but how can you ignore the margin requirement. It is actually the cash set aside by broker to cover your trade risk.
You sold $6 long spread whose maximum value is $600. To cover the risk of this maximum value on the spread broker takes $600, thus reducing your OBP to $7,400. The credit of $100 gets added into your account, which increases your OBP to $7,500.
Now, your stock buying power is $15, 000, it is twice the OBP with 50% margin.
You can see how your OBP has decreased with the risk factor related to trade. It also means that selling put spread is generally same as debit trade. In brief, money to invest in trade or withdraw gets reduced by trade risk margin. As all opening trades carry risk, the OBP is less, so these are actually ‘debit’ trades.
Another way to understand this theory
You are hired to perform a job and get paid $100 upfront but simultaneously, you will need to pay $600 as a deposit against risk of not getting the job done right. You get the entire deposit refunded, when the job gets done correctly. You received $100 upfront and had to pay $600 [as deposit] to make a trade. Here the word ‘credit’, which means money received, gives a twisted feel. To receive a credit of $100, you needed to pay more money [$500 from your pocket].
In terms of interest, you will gain interest on credit of $1 but not on the margin requirement of $6. Again, you are sacrificing your interest on $5, which is another risk of trade.
In an income trade, there is NO INCOME until –
- You pay money to brokers for placing trade
- Trade is closed for a profit
Once the put spread gets expired worthless then $600 margin requirement will be put back in your account along with the $100 income, you earned. Your option buying power increases to $8,100.
The concept of thinking debit trades for money pay out and credit trades for money received is so strong that every opening option trade are actually debit transactions, even if they are labeled credit transactions. Your spendable cash increases only, when you close the trade for PROFIT.