When deciding between trading credit spreads or debit spreads, it can be helpful to align the options strike prices and expirations with the level and direction of implied volatility.
Implied volatility can play a role in deciding between credit and 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).
Start by identifying the level of IV, which plays a crucial role in the pricing of options. When IV is relatively high, options tend to be expensive, and savvy traders prefer to sell them to maximize their credit. When IV is relatively low, options prices tend to be cheap, and—you guessed it—savvy traders prefer to buy options designed to minimize their cost, excluding transaction costs. Keep in mind that volatility can always go higher or lower, which is why it’s a good idea to put volatility in the context of IV percentile, which compares current IV to past highs and lows.
The IV levels can be found on the thinkorswim® platform from TD Ameritrade under the Analyze or Trade tab. Look in Today’s Options Statistics, found below the Option Chain. There are several volatility stats listed here, and each has its benefits and uses. But for now, we’ll focus on IV and IV percentile.
As a general rule, some traders consider buying a debit spread when IV is between the 0 to 50% percentile of its 52-week range (see figure 1). That’s because credit spreads tend to be less expensive, and as a result, profits could be smaller.
When IV is higher, the credit spreads become more expensive. You might consider selling a credit spread when IV is greater than the 50% percentile of its 52-week range. The potential profits could be larger and potential losses could be smaller.
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 options 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. To view implied volatility on a price chart on thinkorswim, from the Charts tab, select Studies > Add Study > Volatility Studies > ImpVolatility (see figure 2).
So if the IV percentile is above 50%, you could consider options with expirations that line up with the time frames of the direction of the trade. For example, if you think a stock might rise in the next 30 days, you could find an option with an expiration that’s about 30 days out.
It’s worth pointing out that there are countless ways to construct vertical spreads with various strike prices, time to expiration, and IV levels. A lot depends on the timing and movement of the underlying asset.
Generally speaking, debit spreads tend to be more directional, whereas credit spreads are more about collecting premium. But bottom line, all else being equal, it’s important to align the trade with the level and direction of implied volatility. Keep in mind that multiple-leg option strategies can entail additional transaction costs, including multiple contract fees, which may impact any potential return.
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Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Maximum potential reward for a debit spread is limited to the difference between strikes, less net premium paid. The maximum loss is the net premium paid and transaction costs.Maximum potential reward for a credit spread is limited to the net premium received, less transaction costs. The maximum loss is the difference between strikes, less net premium received, plus transaction costs.
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