When trading or investing in options, there are two main option spread strategies, credit spreads and debit spreads. Credit spreads are options strategies that involve receipts of premiums, whereas debit spreads involve payments of premiums.
A credit spread involves selling, or writing, a high-premium option and simultaneously buying a lower premium option. The premium received from the written option of the spread is greater than the premium paid for the long option, resulting in a premium being credited into the trader or investor's account when the position is opened. When traders or investors use a credit spread strategy, the maximum profit they can receive is the net premium.
For example, an investor implements a credit spread strategy by writing one March call option with a strike price of $30 for $3 and simultaneously buying one March call option at $40 for $1. Since the usual multiplier on an equity option is 100, the net premium received is $200 for the trade, and he will profit if the spread strategy narrows.
Conversely, a debit spread involves buying an option with a higher premium and selling an option with a lower premium, where the premium paid for the long option of the spread is more than the premium received from the written option. Unlike a credit spread, a debit spread results in a premium being debited, or paid, from the trader's or investor's account when the position is opened.
For example, a trader buys one May put option with a strike price of $20 for $5 and simultaneously sells one May put option with a strike price of $10 for $1. Therefore, he paid $4, or $400 for the trade. If the trade is out of the money, his max loss is reduced to $400, as opposed to $500 if he only bought the put option.
(For related reading, see "Taking Advantage of Volatility Spikes With Credit Spreads.")