Choosing a New Options Spread

In your experience, is it better to use debit and credit spreads on exchange-traded funds (ETFs) or stocks? I have been strictly a buyer of calls and puts, which worked well from 1998 to 2001, but I wanted to expand into basic debit and credit spreads. Any general strategies for spreads? -- JCF

This needs to be answered in a few stages. First, definitions. A vertical credit spread is the sale of a closer-to-the-money option (higher-priced) with the purchase of a further out-of-the-money option (lower-priced) with the same expiration date on a one-to-one basis. The profit is limited to the net credit or amount of premium collected and the loss is limited to the difference between strike prices minus the net credit.

Next, before getting to whether different strategies work better when applied to ETFs or stocks, it will be instructive to compare debit vs. credit spreads in general. The normal assumption is that a straight vertical credit spread is more attractive and will outperform a debit spread if volatility is high but is expected to decline. But in reality this is not necessarily true; both should perform the same.

The fact is, if you are utilizing the same strikes, a bullish call spread (a debit spread) and a bullish put spread (a credit spread) should be priced to present the same risk/reward. Otherwise, a risk-free arbitrage situation would be present, which market-makers would take advantage of. (See this article on parallel positions and the concept of looking at the box spread for pricing options.)

As always with options, one should be looking to buy "cheap" options and sell "expensive" options. The very nature of a vertical spread, the simultaneous purchase and sale of related options, means that a change in implied volatility should have minimal impact on the position's performance.

Striking Out

Because spreads tend to be employed as directional or price-based positions rather than bets on volatility, they are usually established using out-of-the-money strikes. The further out of the money, the less profit potential a credit spread offers over its mirror credit spread.

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