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.
