Choosing a New Options Spread

For example, with the Nasdaq 100 Trust(QQQ Quote) trading at $35, the November 36/38 call spread can be bought for a net debit of 55 cents, giving it a maximum profit of $1.45.

The November debit spread with the same strikes (sell the $38 put, buy the $36 put) can be sold for a net credit of $1.45 (which is also the maximum profit) giving it a similar 55 cents risk. These are essentially the same position and will produce the same profit/loss for any given price of the QQQ.

But the equidistant out-of-the-money credit spread, selling the $34 put and buying the $32 put, generates a credit of just 55 cents (which is the maximum profit) and has a maximum loss of $1.45 per spread. Clearly, as you go further out of the money, the debit spread offers the more attractive risk/reward.

Looking at the positions in the light of price expectations can help determine when a credit or debit spread makes more sense. Obviously, a credit spread makes sense if you believe the underlying price will fail to move into the money of the nearer strike price.

This is important in terms of profit, because the maximum profit on the credit spread can be achieved with a flat stock price in which all options expire worthless. The credit spread does carry the greater risk of early assignment by the option holder, which would present another set of risks entirely.

For the maximum profit to be made on a debit spread, the underlying share price has to move fully into the money, above the strike price of the option sold short. So credit spreads usually should be employed over debit for closer at-the-money strikes when the expectation is that price will remain relatively stable or you don't believe there is a high probability of the stock moving significantly against you.