Debit Spreads

Options Debit Spreads Guide

15 min read

Debit spreads are a directional options strategy. They are risk-defining, meaning the amount you risk is the amount you’ve committed to. They are less risky than buying naked calls and puts. Depending on the strategy, it requires a combination of buying and selling calls or puts with the same expiration date. Employing this strategy lowers your break-even point on the trade, giving you better odds of profit. 

A debit spread involves simultaneous buying and selling calls or puts with different strike prices and the same expiration. It gets the name debit because the money is debited from your account from the start. In essence, you’re paying to make the trade. This differs from credit spreads, where the money is credited to your account immediately.

Options trading strategies are a great way to profit if you’re learning to invest in the stock market with little money. Options give you the right but not the obligation to buy (call) or sell (put) a security at a specified price (strike price) in a certain amount of time (expiration date).

One option contract controls 100 shares of a stock, making options trading cheaper. However, options are riskier, so it is important to study and practice before using real money to trade.

Spreads are less risky than buying naked calls and puts because your risk is limited. Stock options have more going on than stocks—for example, time decay, intrinsic value, and implied volatility.

Each affects calls and puts and must be considered when purchasing options contracts. They can negatively or positively impact the price. 

Options trading can be difficult for new traders to understand. That’s why time spent studying is so important.

Debit Spreads Example

Direction Assumptions

Just like with naked calls and puts, you have to pick the right direction of the market for debit spreads. The good news with a debit spread is that your risk is low if you miss.

A call spread is bullish. This means you believe the stock is going to go up in price. A put spread is bearish. Hence, there is a belief that the price will go down.

Your assumption of market direction decides which debit spread you want to buy. Your profits come from the widening of your premiums. The farther apart your spread goes, the more you profit.

Assumption is a word used a lot in trading. You’re assuming a stock will move a certain way, so you trade based on that. Make the wrong assumption, and you’re in a bad trade. That’s why traders rely on patterns and candlesticks. When deciding what debit spreads you want to open, you must look at the charts.

Debit Spreads Process

Debit spreads are buying and selling options with different prices. It would be best to choose a direction that ensures the stock is in a strong trend.

The option you buy should be in the money. In the money, the call option strike price is below the market price, and the put option strike price is above the market price.

The option you sell should be at or out of the money. At the money is when the strike price matches the market price. Out of the money, there is the call strike above market price and the put strike below market price.

Having the debit spread range between in the money and at or out of the money gives you wiggle room. You’re long in the money and short out of the money. Take your profits when they come. The enemy of profiting is greed. You usually don’t get 100% of your profit potential. Look at the patterns with your profits to ensure you’re not about to give them back. 

Debit spreads are risk-limiting. That’s the appeal of trading any spread with options. It’s important to practice trading them in a paper account like Thinkorswim before using real money. Even though a debit spread limits risk, if you don’t practice first, there is the potential for loss. Practice trading allows you to work out the kinks and find the best strategy for your trading style. 

COMPANY
TradeStation ThinkorSwim Logo Tastytrade Logo
DESCRIPTION Experience TradeStation's professional-grade options trading platform, built for serious traders seeking value and power ThinkorSwim is for more advanced options traders. It features elite tools and lets you monitor the market, plan your strategy, and implement it in one convenient, easy-to-use, integrated place Trade options on stocks, ETFs, and broad-based indices. Trade equity and ETF options online for $1.00 per contract opening commission and $0 commission to close, capped at $10.00 per leg
HIGHLIGHTS

Basics

Like other options spreads, call debit spreads, or “”bull call spreads,”” are bullish options trading strategies with limited risk. A simple way to think of a call debit spread is a long call with some built-in protection in the form of a short call

You’re covered just in case the underlying asset decreases in value. Moreover, the short call reduces your position’s delta and theta.

Although this minimizes your profit, it has the fringe benefit of lowering your risk. The short call is a hedge against buying just a long call position, reducing your risk. Because I like to protect my money, I’m okay with it, even if it means my profit is reduced.

Maximum Profit and Loss

  • Maximum Profit = Width of Strikes – Premium Spent
  • Maximum loss = Premium Spent

Knowing your profit and loss is essential to being a good trader. That helps you plan your trade. A good rule of thumb is to plan your trade and trade your plan.

When you deviate from your plan, you typically take a loss. Always remember this strategy must consist of buying one call option and selling another at a higher strike price to help pay the cost.

The spread typically profits if the stock price moves higher, similar to a regular normal long call strategy, until the short call starts to go in the money.

Call Debit Spreads

Call debit spreads are a bullish directional options strategy. They require combining buying and selling a call with the same expiration date. You would use this strategy instead of buying a naked call to help lower your break-even cost.

Choosing the right direction is important with this trading strategy. It’s also important to consider taking profits along the way, somewhere between 25% and 50%. 

Call Debit Spreads Example

Why People Trade Call Debit Spreads

Typically, you only trade a call debit spread if you feel the price of a stock will increase. In other words, this is a bullish options trading strategy. What’s excellent about call debit spreads is I can go long but with only a fraction of the capital. Quite frankly, this is what makes them so attractive.

As I mentioned in other blog posts, it can be challenging to make money-buying calls. And why? Think of one word: volatility.

Just imagine being in a long-call position and volatility getting slammed. Even if the stock didn’t decrease in price, your long call position would be devastated.

But with a call debit spread, you’re mostly protected from changes in volatility. Even if volatility dramatically decreases, you’re okay because the impact is in both legs (long and short). In other words, the changes are negligible. This is why traders love the call debit spread option strategy.

Closing Out Call Debit Spreads

As a general rule of thumb, close out a call credit spread before expiration if it has reached its maximum profit. Maximum profit occurs if the spread is equal to or very close to the width of the strikes.

So, if your call debit spread reaches its maximum profit, close it out. I also give the same advice for a put debit spread.

Otherwise, you run the risk of your position reversing. And there’s no hope or wish for more money. Your maximum profit is defined. So, take the money and run.

If both the long and short calls expire in the money at expiration, your profit is just the difference in the strike prices.

Call Debit Spreads at Expiration

If expiration time arrives and only the long call portion of your call debit spread is ITM, you could be in trouble. If you don’t have enough money in your account to buy the potential long-call assignment, you have a problem.

The same goes for spreads hovering ATM come expiration day. If the position doesn’t affect your account, your broker will call you and, typically, ask you to close out your position.

Your best case scenario is if both legs of the spread expire ITM. The spreads make money, and no further action is needed.

However, like with all debit spreads, the underlying asset may expire between the strike prices of the long and short options.

Key Takeaways

  • A bullish options trading strategy is used when you think a stock will significantly increase in price
  • For the spread to profit, the underlying asset must increase in price before the expiration
  • An increase in volatility will not increase the value of your spread
  • They protect from a collapse in volatility
  • Your profit and loss is defined
  • Time (theta) decay is not beneficial
  • The spread loses money every day if the underlying price does not increase.
  • They are simply the hedged version of buying calls
  • Worst case scenario is when the stock is between the two strike prices at expiration

Put Debit Spreads

Put debit spreads are a bearish directional options strategy that requires combining buying and selling a put with the same expiration date. Instead of buying a naked put, you would use this strategy to help lower your break-even cost.

Choosing the right direction is important with this trading strategy. It’s also important to consider taking profits somewhere between 25% and 50%. 

In simple terms, a put debit spread is a long put with some built-in protection (a short put). Just in case the underlying asset appreciates, you can cover your butt with the short put.

What’s more, debit spreads are theoretically immune to changes in volatility. This is because of the short-put component of the spread.

Put Debit Spreads Example

Volatility And Options

For the above reasons, debit spreads are quite attractive to options traders in high (implied) volatility markets. It’s also safer to buy put debit spreads instead of conventional puts.

Like all equity vehicles – investments involving ownership – they’re subject to risk. There are no guarantees, and they do fluctuate up and down. But with a spread, you’re protected.

It’s great to have protection from options volatility. While your reward may be limited, you won’t lose much if the trade goes against you. 

Time and direction profoundly affect your good or bad contracts, hence why spreads were developed.

You’re profiting while only risking a little. Remember that options give you the right but not the obligation to buy or sell a stock at a set price within a certain time frame.

One contract controls 100 shares. As a result, they’re safer, inexpensive ways to trade large-cap stocks.

How to Trade Put Debit Spreads

  • Buy one put
  • Sell one put
  • With a strike price further away from the strike price of the put you bought

Put Debit Spread Example

  • Stock ABC is trading at $50 a share
  • Buy 48 put at $0.50
  • Sell 46 put at $0.20

Following the steps above would create a net debt of $0.30 ($30). Hence, the name “debit” spreads because it costs you money to deploy the position.

The debit spread will increase in value if the underlying stock ABC declines in price. Again, remember that you can buy multiple contracts, which pumps the profits up.

Your Maximum Profit and Loss

  • Maximum Profit = Width of Strikes – Premium Spent
  • Maximum Loss = Premium Spent

The difference between the width of the two strikes minus the Premium paid to enter put debit spreads is always your maximum profit. In the example above, the most you can make on the trade is $1.70 ($170).

The most you can lose is the amount you paid to enter the spread, $0.30 ($30). When ABC trades at or below the short option leg of the spread ($46) at expiration, you’ll have your maximum profit.

Conversely, your spread will decrease if the stock increases in value before expiration. 

COURSE
Day Trading Course Options Trading Course Futures Trading Course
DESCRIPTION Learn how to read penny stock charts, premarket preparation, target buy and sell zones, scan for stocks to trade, and get ready for live day trading action
Learn how to buy and sell options, assignment options, implement vertical spreads, and the most popular strategies, and prepare for live options trading How to read futures charts, margin requirements, learn the COT report, indicators, and the most popular trading strategies, and prepare for live futures trading
INCLUDED

Why People Trade Put Debit Spreads

Let’s be clear; you only deploy put debit spreads if you feel the stock price will decline. What’s excellent about put debit spreads is I can still short but with only a fraction of the capital. How great is that? More often than not, seasoned traders will probably nod their heads in agreement. It can be tough to make money buying uncovered puts.

And why? Think of one word: volatility. Good luck if you’re long on put options and a volatility crush hits. Your pocketbook is in for a hit.

Furthermore, puts are expensive to purchase and hold. First, because they almost always trade at a premium to calls. Second, they are costly to hold because there is more premium to decay.

What’s excellent with a put debit spread is that you’re mostly protected from changes in volatility. Even if volatility dramatically decreases, you’re okay because both the legs (long and short) are impacted.

You’re probably thinking, Ali, how is that okay? It’s because the result is neutral. This is why traders love the put-debit spread option strategy.

Put Debit Spreads at Expiration

If expiration time arrives and only the long call portion of your put debit spread is ITM, you could be in trouble. If you need more money in your account to buy the corresponding number of puts, you have a problem.

The same goes for spreads hovering ATM come expiration day. If the position creates a negative margin impact on your account, your broker may call and ask you to close out your position.

Your best case scenario for put debit spreads is having both legs of the spread expire ITM. The spreads make money, and no further action is needed.

But, like with all debit spreads, you run the risk of the underlying expiring between the strike prices. What does that mean exactly? 

However, it would be best not to rely on anyone else for these warnings. Monitor your positions and know when they expire. That’s what great traders do.

Key Takeaways

  • Put debit spreads are strictly bearish and best for a bearish market outlook
  • If the underlying asset goes down in price, the debit spread will increase in value
  • They will not increase in value if volatility increases
  • An excellent strategy for shorting an asset without outright purchasing puts
  • Utilize them when you think a stock will decline in price, but long puts are too risky
  • Your profit and loss is limited
  • Time (theta) decay is not beneficial
  • Every day, the spread loses money if the underlying does not decrease in price.

In conclusion, when you think a stock will decline in price but long puts are too risky, put debit spreads could be a great option. Your risk is capped, making it a safe choice instead of buying a long put.

Please remember that time decay is not on your side, and the option’s value doesn’t increase if there is volatility. If the underlying sells off after expiration, it won’t be a winning trade.

In other words, for put debit spreads to be profitable, the underlying needs to move down in price.

Frequently Asked Questions

A debit spread can be bullish or bearish depending on whether it's a call debit spread or a put debit spread. Call debit spreads are a bullish strategy, and put debit spreads are a bearish strategy.

  • Buy 1 call with a strike of 95 @ $3.30  
  • Sell 1 call with a strike of 100* @ $1.50
  • The strike price must be further away from the strike price of the long call you bought

Similar to most options strategies, you can trade them in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). Your actual cost for the play is $1.80 because you received some premium as a debit (it's a debt)! Get it?

Debit spreads are better than credit spreads for profit potential but not for winning percentage. Credit spreads have a better win rate but less profit potential than debit spreads.

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