The other day a customer wrote an email asking about debit and credit spreads. He had been working with another vendor’s material and had somehow thought that memorizing “right to buy” and “obligation to sell” was about all he had to do to get through this whole options thing. In my book, I explain that if you buy the ABC Oct 50 call and sell the ABC Oct 55 call, you have created a debit spread. Why? The right to buy stock at $50 is worth more than the right to buy it for $55.
Whoah–slam the brakes, shut the system down, this guy was not happy with that explanation. He was convinced that there WAS no right to buy stock at $55 since this guy SOLD that call. This is why rigid thinking can be so detrimental on the Series 7 exam. The little options quadrant that everyone learns is helpful in some cases, but–like the T-chart–has its limitations, too. I need you to accept this statement, everyone: a call option is the RIGHT TO BUY stock at a set price.
You can buy that right, sell that right, or just take a pass on the whole thing. Okay? Whatever the premiums are, somebody paid more for the right to buy ABC for $50 than anyone paid for the right to buy it for $55. This guy bought the more valuable call and sold the less valuable call. Debit to his account. More money went out than came in. On the other hand, if he buys an ABC Dec 40 call and sells an ABC Dec 30 call, he sells the more valuable option and, therefore, starts with a credit. Whatever the premiums are, the right to buy stock for $30 is worth more than the right to buy it for $40. He took in more money than he spent. A credit to his account; credit spread.
I know it’s hard to see this without the premiums provided, but you have to learn how to do that for your exam. What really helped me see this concept was pulling up real-world quotes on options. You’ll see calls on the left, puts on the right. And, you’ll see that as strike prices drop, call premiums rise and put premiums fall. Until you can see that and understand it fully, options questions will likely seem like a major challenge when, in fact, they should be among the easiest questions you encounter at the test center.