Debit spreads are a directional options strategy. A debit spread is risk defining meaning the amount you risk is the amount you’ve committed to. They are less risky than buying naked calls and puts. It requires doing a combination of buying and selling calls or puts, depending on the strategy, with the same expiration date. When you employ this strategy it lowers your break even point on the trade which gives you better odds of profit.
Table of Contents
- What Are Debit Spreads and How Do They Work?
- Call Debit Spreads
- Put Debit Spreads
- How to Trade Put Debit Spreads
- Frequently Asked Questions
What Are Debit Spreads and How Do They Work?
A debit spread is the simultaneous buying and selling of calls or puts with different strike prices and same expiration. It gets the name debit because the money is taken out of your account from the get go. In essence, you’re paying to make the trade. The money is debited from your account. This differs from credit spreads where the money is credited to your account right from the start.
Options trading strategies are a great way to profit if you’re learning how 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 options contract controls 100 shares of a stock. Options trading is cheaper because of that. However, options are riskier. Hence the importance of studying and practicing 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 as well as implied volatility.
Each of these affect calls and puts and must be taken into consideration when purchasing options contracts. Not only can they affect price negatively but they also can have a positive impact on price.
Options trading can be difficult to understand for new traders. That’s why time spent studying is so important.
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 if you miss, you’re risk is low.
A call spread is bullish. This means you believe the stock is going to go up in price. A put spread is bearish. Hence the belief that price will go down.
Your assumption on 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 is going to 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 you’re trying to decide what debit spreads you want to open you need to look at the charts.
Debit spreads are buying and selling options with different prices. You need to chose a direction so make sure the stock is in a strong trend one way or the other.
The option you buy should be in the money. In the money means that the call options strike price is below the market price and the put option strike 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 has 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 in conjunction with your profits just to make sure you’re not about to give them back.
Debit spreads are risk limiting. That’s the appeal in 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 style of trading.
Call Debit Spreads
Call debit spreads are a bullish directional options strategy. It requires doing a combination of buying a call 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 25-50%.
Basics of Debit Spreads
Like other options spreads, call debit spreads or “bull call spread,” is a bullish option trading strategy 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.
Just in case the underlying asset decreases in value, you’re covered. What’s more, the short call reduces the delta and theta of your position.
Although this minimizes your profit, it has the fringe benefit of lowering your risk. The short call acts as a hedge against buying just a long call position. This reduces your risk. Because I like to protect my money I’m okay with it! Even if it means my profit was reduced.
Debit Spread Example
- 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 is $1.80 for the play, because you recieved some premium as a debit (its a debt)! Get it?
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, plan your trade and trade your plan.
When you deviate from your plan, you typically end up taking 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 would, up to the point where the short call starts to go in the money.
Why Do 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 one word: volatility.
Just imagine being a long call position and volatility gets 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 ok because the impact is in both the legs (long and short). In other words, the changes are negligible. This is why traders love the call debit spread option strategy.
When Should You Close out Call Debit Spreads
As a general rule of thumb, close out a call credit spread before expiration if the spread has reached its maximum profit. Maximum profit happens if the spread is equal or very close to the width of the strikes.
So, if your call debit spread reaches its maximum profit, do the wise thing and close it out. I give the same advice for a put debit spread as well.
Otherwise, you run the risk of your position reversing. And there’s no hoping or wishing for more money. Your maximum profit is defined. So, take the money and run.
In the event that both the long and short call expires in-the-money at expiration, your profit is just the difference in the strike prices.
What Happens to a Call Debit Spread at Expiration?
If expiration time arrives and only the long call portion of your call debit spread is ITM, you could be in for trouble. If you don’t have enough money in your account to buy the potential long call assignment, you have a problem on your hands. The same goes for spreads that are hovering ATM come expiration day. If the position creates a negation margin impact on your account, expect a call from your broker. Typically they will 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.
But like with all debit spreads, you run the risk of the underlying asset expiring between the strike prices of the long and short options.
Call Debit Spread Key Takeaways
- A bullish options trading strategy 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
- Every day the spread loses money if the underlying does not increase in price
- 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. It requires doing a combination of buying a put and selling a put with the same expiration date. You would use this strategy instead of buying a naked put 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 25-50%.
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, put debit spreads are theoretically immune to changes in volatility. This is because of the short put component of the spread.
Volatility And Options: Two Peas In a Pod
It’s for these reasons mentioned above, put debit spreads are quite attractive to options traders in high (implied) volatility markets. What’s more, it’s a safer bet to buy put debit spreads instead of conventional puts.
Like all equity vehicles – that is, 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.
Protection with the volatility of options is a great thing. While your reward may be limited, you aren’t losing a lot if the trade goes against you.
Things like time and direction have a profound affect on your contracts, whether good or bad. 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 1 put
- Sell 1 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
If you followed the steps above, you would create a net debt of $0.30 ($30). Hence the name “debit” spread 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, don’t forget that you can buy multiple contracts. Doing so pumps the profits up.
Your Maximum Profit and Loss
- Maximum Profit = Width of Strikes – Premium Spent
- Maximum Loss = Premium Spent
The fact is, 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).
Whereas the most you can lose is the amount you paid to enter the spread, $0.30 ($30). When ABC is trading at or below the short option leg of the spread ($46) at expiration, you’ll have your maximum profit.
On the flip side, if the stock increases in value before expiration, your spread will decrease in value.
What Do People Trade Put Debit Spreads?
Let’s be clear; you only deploy put debit spreads if you feel the price of a stock 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 one word; volatility. If you’re long on put options and a volatility crush hits, good luck. 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, you’re mostly protected from changes in volatility. Even if volatility dramatically decreases, you’re ok because both the legs (long and short) are impacted.
You’re probably thinking Ali, how is that ok? It’s because the end result is neutral. This is why traders love the put debit spread option strategy.
When Should You Close out Put Debit Spreads
As a general rule of thumb, never close out put debit spreads that have lost all value before expiration. Because risk is defined, you can’t lose more.
Also, the spread can regain its lost value before expiration. That’s pretty great if you ask me.
However, if your put debit spread reaches its maximum profit, do the wise thing and close it out. Otherwise, you run the risk of your position reversing.
And there’s no hoping or wishing for more money; your maximum profit is defined. So, take the money and run. You never go broke taking your profits.
What Happens to 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 for trouble. If you don’t have enough money in your account to buy the corresponding number of puts, you have a problem on your hands. The same goes for spreads that are hovering ATM come expiration day. If the position creates a negation margin impact on your account, your broker may call. Typically they will ask you to close out your position.
Your best case scenario for put debit spreads are 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?
Let’s be clear though; I don’t want you to rely on anyone else for these warnings. Monitor your positions and know when they expire. That’s what great traders do.
Put Debit Spread 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. And your risk is capped; which makes it a safe choice as opposed to buying a long put.
Keep in mind time decay is not on your side, and the value of the option doesn’t increase if volatility increases. Typically, if the underlying doesn’t sell-off before 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
Is a Debit Spread Bullish or Bearish?
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.