Derivatives: why would you ever do a debit spread?

CFA Level III Derivatives
#1

Reviewing derivatives and I am befuddled over debit and credit spreads. A bull call spread (debit) has the same risk profile as a bull put spread (credit), but one results in a cash outflow and ones an inflow. If one is looking to take a bullish position an wants to do a spread, why would they ever choose the one that costs them money and not the one that pays them? In the similar vein, if they have the same risk profile, shouldn’t they cost the same?

#2
  • An options spread is a strategy that involves the simultaneous buying and selling of options on the same underlying asset.
  • A credit spread involves selling a high-premium option while purchasing a low-premium option in the same class or of the same security, resulting in a credit to the trader’s account.
  • A debit spread involves purchasing a high-premium option while selling a low-premium option in the same class or of the same security, resulting in a debit from the trader’s account.

Hope this helps.

#3

Assuming that the options are fairly priced, they have identical profits. The only difference is the timing of the cash flows; they are equivalent (but not identical).

#4

Thanks aparnake, I think I have that down pretty well. I am thinking of the implementation of these spreads and when you would want to use one and not the other. Wouldn’t you always would rather be paid and not lose money?

#5

Of course you would.

But that’s not what happens in, say, a bull put spread, or a bear call spread. In each, the payoff is either zero or negative, and you can lose money.

Take a look at an article I wrote on bear spreads: http://financialexamhelp123.com/bear-spread/.

#6

I’ve never traded options, so I’m just spitballing here. I suspect that the choice between a credit spread and a debit spread would (possibly, or, perhaps, likely) be made by comparing your borrowing rate and your investment rate to the risk-free rate implicit in the options:

  • If you can borrow at a lower rate than the rate implicit in the options, you would choose a debit spread
  • If you can lend at a higher rate than the rate implicit in the options, you would choose a credit spread
  • If neither of those occurs (which is, I suspect, the most likely case), then you do a little more detailed analysis and choose the approach that has the higher total profit
#7

The answer to your question is the footnote 19 of reading 15 (page 256).
Basically, you have the extra risk of the option you sold (in bull put spread the high strike one, in bear call spread the low strike one) being called early because they are American style. The other option would not be in the money yet, therefore you may lose more than what you had as initial inflow.

#8

sorry…i didn’t read your question properly…hope you got your answers :slight_smile:

#9

My 2 cents (more a trader’s view than a curriculum view)
If your view is an option at a certain strike will expire OTM - you sell it. Hedging it by buying a far OTM option . This is a credit spread
However if you have a directional view on the market/or volatility , you buy an option (closer to money) but fund it partially through selling an OTM option (also giving up unlimited profit). This is a debit spread
At times even when you want to take advantage of the theta decay, but hedge delta , you may enter a calendar spread. Short near expiry, long far expiry. This is also a debit spread