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In the Options Alerts model portfolio, I often sell vertical credit spreads. These consist of selling a higher-priced option and simultaneously buying a lower-priced option with the same expiration on a one-to-one basis in order to establish a directional position. Whenever I employ this strategy, I can count on getting a few questions.

The most common: Why did I decide to use this strategy? What are the advantages to using such a strategy over the more common debit spread, which is constructed through the purchase of a lower strike or more expensive option and the sale of a lower-priced option?

Let's start answering these by looking at vertical credit spreads have in common with debit spreads. Both are limited-risk positions. They mirror each other, being basically the inverse of each other. But their risk/reward profiles are very different. In a credit spread, you typically trade a lower maximum profit for a higher probability of profit.

Credit vs. Debit

For example, I recently wanted to establish a bearish position in Unibanco Brasileiros (UBB - commentary - Cramer's Take) on the notion that the stock might be forming a double top at the $90 level. With the stock trading around $90.50 this morning, I could sell the January $90/$95 call spread for around a $2 net credit -- $2.50 for the $40 call and 50 cents for the $95 call.

To achieve the position's maximum profit, $2, all it takes is a 0.05% decline or for the shares of UBB to be at any price below $90 on the Jan. 19 expiration. The maximum loss is $3 and is incurred in UBB if it's above $95, a 5% move, on expiration. The breakeven point is $92 or a 2.2% increase in price. If the stock remains unchanged at $90.50, the position would realize a $1.50 profit.

Compare this to the similar bearish position of buying the $90/$85 puts spread for a net debit of $2 for the spread. In this case, the maximum profit of $3 is realized if shares decline below $85, a 5% price move. The maximum loss is just $2, but would be incurred if shares of UBB were at any price above $90 at expiration, meaning even a small decline in share price can result in the maximum loss. Note, the $95/90 bear put spread, which would cost $3 net debit, is the exact same as the $90/$95 credit call spread.

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Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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