Spreads

The purpose of a spread trade is to limit your risk, while the consequence is that your reward is also limited. (This is distinct from the purchase of a straight call option where your gains can, in theory, be unlimited.) You can't lose more than you invested, while the profit is limited to the difference between the strike prices of the options making up the spread less the premium paid.

While there are many different ways to construct a spread, they all fall into one of two categories - that is, they are are either debit spreads or credit spreads. The easiest way to determine if a spread is debit or credit is to look at the leg that is sold. If it is closer to the money (i.e. the current share price) than the bought leg, then it will be a credit spread, as options closer to the money have more intrinsic value than options further away from the money.

:: Debit Spreads

With a debit spread, you will need to put money into the market in order to enter the position (as was the case with buying calls and puts). The debit is created by buying a call or put while at the same time selling a further out-of-the-money call or put - as the cost of the bought option exceeds the income from the sold option, your account will be debited. The opposite is the case with a credit spread. Debit spreads work best in more volatile, trending markets - since you enter the position in debit, you need some degree of movement in the market for the spread to become profitable.

:: Credit Spreads

Credit spreads use margin, which is the amount of money your brokerage firm will require you to maintain in your account to cover the possibility of the trade going against you. This, effectively, is what the trade will "cost" you, as it is the basis upon which the return of the trade is calculated. The margin calculation we use is the one optionsXpress require of their customers - 100% of the difference between the two strike prices less the credit received from entering the position. You can see how both the margin and the return on a credit spread are worked out in Returns. Credit spreads are better suited to a flatter market - as you already have your profit in hand when you enter the position, you need the market to stay approximately where it was when you initiated the position in order to retain that profit. The goal of the credit spread is to have both options expire worthless, allowing you to keep the entire premium.

To illustrate how debit spreads work, we're going to look at two vertical debit spreads (they're called vertical because both the options that make up the spread expire in the same month) and two vertical credit spreads, which are:

Debit Spreads	Credit Spreads
Bull Call Spread	Bull Put Spread
Bear Put Spread	Bear Call Spread