Credit Spreads Vs. Debit Spreads: A Profit/Loss And Risk Comparison

|
 |  Includes: AAPL, INTC, PCLN
by: Kevin M. O'Brien

I could probably write 100 articles on this subject alone: what is a better trade, a credit spread or a debit spread. To compare the two, I think it is necessary to show examples of stocks or ETFs that I use.

One of the many drawbacks of a credit spread is that it will tie up so much capital. I understand the many points and certain benefits of them, such as not getting exercised on your position. I think credit spreads are fine to use if you have little capital to work with and are extremely conservative. There are just too many other option strategies out there that I feel are far better, along with providing higher return on investment.

If you are working with a larger amount of cash, the temptation to go 'heavy" on a trade with an Iron Condor is ever-present because of the lower ROI.

One aspect I would really like to point out is that time is not necessarily a good thing to have with an Iron Condor, but this aspect often gets lost on many traders.

Take in point someone I know. He was using a credit spread (the iron condor) on Priceline.com (NASDAQ:PCLN), and going out one month with the trade. It definitely was not a good stock to use an Iron Condor with to begin with, just like Apple (NASDAQ:AAPL) is not. He got it handed to him on that trade. This is a great example of what type of stocks to avoid with an Iron Condor. If someone tells you it is a good idea or you read an article suggesting this is a good trade, they do not understand this trade fully, or they certainly do not follow the stock and the markets thoroughly enough.

Still, I will show a comparison between an Intel (NASDAQ:INTC) trade using a Iron Condor and a "Long Put Butterfly" spread, which is placed as a net debit. Intel is currently trading at $26.92/share.

I will leave it up to the reader to decide what is the better choice.

Trade Example #1A: Intel

Iron Condor - credit spread

Sell 25 INTC April 2012 $26.00 put options
Buy 25 INTC April 2012 $25.00 put options
Sell 25 INTC April 2012 $28.00 call options
Buy 25 INTC April 2012 $29.00 call options

Requirements

Cost/Proceeds ($1,175.00)
Option Requirement $2,500.00
Total Requirements $1,325.00
Estimated Commission $125.00
Click to enlarge

Current Price: $26.92

Price Profit / Loss ROM %
18.75 ($1,325.00) -53.00%
22.11 ($1,325.00) -53.00%
25.00 ($1,325.00) -53.00%
25.53 $0.00 0.00%
25.64 $285.00 11.40%
26.00 $1,175.00 47.00%
28.00 $1,175.00 47.00%
28.47 $0.00 0.00%
29.00 ($1,325.00) -53.00%
29.18 ($1,325.00) -53.00%
36.25 ($1,325.00) -53.00%
Click to enlarge

Trade Example #1B: Intel

Long Put Butterfly Spread - debit spread

Buy 25 INTC April 2012 $25.00 put options
Sell 50 INTC April 2012 $27.00 put options
Buy 25 INTC April 2012 $29.00 put options

Requirements

Cost/Proceeds $1,800.00
Option Requirement $0.00
Total Requirements $1,800.00
Estimated Commission $125.00
Click to enlarge

Current Price: $26.92
Price Profit / Loss ROI %
18.75 ($1,800.00) -100.00%
22.11 ($1,800.00) -100.00%
25.00 ($1,800.00) -100.00%
25.64 ($190.00) -10.56%
25.72 $0.00 0.00%
27.00 $3,200.00 177.78%
28.28 $0.00 0.00%
29.00 ($1,800.00) -100.00%
29.18 ($1,800.00) -100.00%
32.71 ($1,800.00) -100.00%
36.25 ($1,800.00) -100.00%
Click to enlarge

Trade Example #1C Intel

Neutral Calendar Spread - debit spread- weekly options on first leg.

Sell 25 March Week 2 INTC $27.00 call options
Buy 25 March (3rd Friday of the month) $27.00 call options

Requirements

Cost/Proceeds $300.00
Option Requirement $0.00
Total Requirements $300.00
Estimated Commission $62.50
Click to enlarge

Current Price: $26.92

Price Profit / Loss ROI %
20.19 ($300.00) -100.00%
22.79 ($300.00) -100.00%
25.53 ($277.50) -92.50%
26.43 $0.00 0.00%
27.00 $515.00 171.67%
27.60 $0.00 0.00%
28.27 ($230.00) -76.67%
31.01 ($287.50) -95.83%
33.75 ($287.50) -95.83%
Click to enlarge

For comparison, I will use Apple as a trade candidate (which I would never do using a neutral strategy that requires little movement in the underlying stock at this time), just to see the difference between a credit spread:

Apple Trade #1a - Iron Condor - Credit Spread

Sell 10 AAPL April 2012 $540.00 put options
Buy 10 AAPL April 2012 $535.00 put options
Sell 10 AAPL April 2012 $550.00 call options
Buy 10 AAPL April 2012 $555.00 call options

Requirements

Cost/Proceeds ($4,550.00)
Option Requirement $5,000.00
Total Requirements $450.00
Estimated Commission $50.00
Click to enlarge

Current Price: $545.18

Price Profit / Loss ROM %
401.25 ($450.00) -9.00%
457.39 ($450.00) -9.00%
516.48 ($450.00) -9.00%
535.00 ($450.00) -9.00%
535.45 $0.00 0.00%
540.00 $4,550.00 91.00%
550.00 $4,550.00 91.00%
554.55 $0.00 0.00%
555.00 ($450.00) -9.00%
575.57 ($450.00) -9.00%
693.75 ($450.00) -9.00%
Click to enlarge

Apple Trade #2b - Long Put Butterfly Spread - Debit Spread

Buy 10 AAPL April 2012 $530.00 put options
Sell 20 AAPL April 2012 $545.00 put options
Buy 10 AAPL April 2012 $560.00 put options

Requirements

Cost/Proceeds $1,600.00
Option Requirement $0.00
Total Requirements $1,600.00
Estimated Commission $50.00
Click to enlarge

Current Price: $545.18

Price Profit / Loss ROI %
397.50 ($1,600.00) -100.00%
455.56 ($1,600.00) -100.00%
516.67 ($1,600.00) -100.00%
530.00 ($1,600.00) -100.00%
531.60 $0.00 0.00%
545.00 $13,400.00 837.50%
558.40 $0.00 0.00%
560.00 ($1,600.00) -100.00%
577.78 ($1,600.00) -100.00%
638.89 ($1,600.00) -100.00%
700.00 ($1,600.00) -100.00%
Click to enlarge

Apple Trade #1c - Neutral Calendar Spread - Debit Spread- Monthly

Sell 10 AAPL April 2012 $545.00 call options
Buy 10 AAPL May 2012 $545.00 call options

Requirements

Cost/Proceeds $6,950.00
Option Requirement $0.00
Total Requirements $6,950.00
Estimated Commission $25.00
Click to enlarge

Current Price: $545.18

Price Profit / Loss ROI %
408.75 ($6,948.00) -99.97%
461.09 ($6,588.00) -94.79%
515.21 $0.00 0.00%
516.19 $263.00 3.78%
545.00 $11,289.00 162.43%
571.28 $1,836.00 26.42%
579.08 $0.00 0.00%
626.38 ($5,562.00) -80.03%
681.48 ($6,492.00) -93.41%
Click to enlarge

Apple Trade #1d - Neutral Calendar Spread- Debit Spread- Weekly

Sell 10 AAPL March Week 2 $545.00 call options
Buy 10 AAPL March (3rd Friday exp.) $545.00 call options

Requirements

Cost/Proceeds $3,600.00
Option Requirement $0.00
Total Requirements $3,600.00
Estimated Commission $25.00
Click to enlarge


Current Price: $545.18

Price Profit / Loss ROI %
408.75 ($3,600.00) -100.00%
461.09 ($3,600.00) -100.00%
516.19 ($2,593.00) -72.03%
530.28 $0.00 0.00%
545.00 $5,471.00 151.97%
560.74 $0.00 0.00%
571.28 ($1,930.00) -53.61%
626.38 ($3,494.00) -97.06%
681.48 ($3,495.00) -97.08%
Click to enlarge

You can always adjust the contract amounts to suit your risk tolerance for each trade. Instead of ten contracts on each "leg," you can use a much lower amount.

I plan to write an extensive article on the neutral calendar spread in the coming weeks.

Disclosure: I am long AAPL.