February 4, 2016

Difference between debit and credit spreads (option lovers)

The amount of potential risk compared to potential reward in a credit trade is typically higher than the risk to reward ratio of the debit trade. 

So why would a trader pick a credit trade over a debit trade? 

The answer lies in probability and the number of trends optimized by the trades. 

A debit trade almost always requires a trending equity. It can be bullish or it can be bearish but the equity needs to move. 

By contrast, a credit trade can be profitable in several trends. Since the primary instrument in a credit trade is a short option, the passage of time in and of itself can take this trade to its maximum profit. The equity does not have to trend in order to be profitable. If the equity trends in the direction favorable to the short option the trade will be profitable and may offer the opportunity to close the trade early. So a credit trade typically can optimize three trends. 

That makes the probability of the trade going to a successful conclusion higher than that of the debit trade.

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