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Choosing Credit Spreads vs. Debit Spreads: Let Volatility Decide

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July 16, 2015
Weighing options: credit vs. debit spreads

Vertical spreads are among the first strategies that option traders learn because they’re relatively straightforward and have defined risk profiles. Vertical spreads come in two flavors: credit spreads and debit spreads. But many traders struggle to choose one over the other. All else being equal, picking the right spread sometimes boils down to the level and direction of implied volatility (IV). 

On the Level?

Start by identifying the level of implied volatility, which plays a crucial role in the pricing of options. When implied volatility is relatively high, options tend to be expensive, and savvy traders prefer to sell them to maximize their credit. When IV is relatively low, option prices tend to be cheap, and—you guessed it—savvy traders prefer to buy options designed to minimize their cost, excluding transaction costs. 

As a general rule, some traders consider buying a debit spread when IV is between the 0 to 33% percentile of its 52-week range. Likewise, you might consider selling a credit spread when IV is between the 67% to 100% percentile of its 52-week range (figure 1).

Implied volatility and percentile ranking

FIGURE 1: SWEET SPOT?

Side-by-side examples compare a current level of implied volatility (IV) and its percentile ranking for the last 52 weeks. For illustrative purposes only.  

Right Direction?

Now, let’s talk about the direction of implied volatility. Direction matters because options trades are exposed to changes in IV—also known by its option greek term vega—for the duration of the trade. 

Debit spreads are designed to almost always have a positive vega and benefit when IV rises over time. This ideally allows you to sell the spread for more than you paid for it. Credit spreads almost always have a negative vega, and benefit when IV falls over time. This makes sense because as IV falls, options become less expensive and are cheaper to buy back to close the trade.

As another general rule, some traders consider buying debit spreads when IV is low and rising. Likewise, they consider selling credit spreads when IV is high and falling (figure 2) 

Charting implied volatility

FIGURE 2: ON TREND? Charting tools can help with some of the heavy lifting, including tracking implied volatility over time. This is useful for gauging the direction of the trend and possible turning points. For illustrative purposes only.

It’s worth pointing out that there are countless ways to construct vertical spreads with various strike prices, time to expiration, and levels of IV. Much of the trade will depend on the timing and movement of the underlying asset.

But bottom line, all else being equal, it’s important to align the trade with the level and direction of implied volatility to give your trade the best chance of success.