Watch our video on how to trade debit spreads. Trading debit spreads a fundamental technique for swing trading options traders.
What Are Debit Spreads and How to Trade Them?
- What are debit spreads? 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.
Debit spreads are one of the many options strategies available to you. A debit spread is risk defining meaning the amount you risk is the amount you've committed to. Watch our video above on how to trade debit spreads.
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. Read our post on put and call options explained.
Options trading can be difficult to understand for new traders. That's why time spent studying is so important.
1. 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 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.
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.
If you're trading options for a living you want to minimize loss as much as possible. That's why candlesticks patterns are important. Candlesticks are the gauge of traders emotions.
When you group those candlesticks together you get patterns. Those patterns give you a direction. However, patterns break down all the time because bullish and bearish patterns form within each other.
You need to be able to see the big patterns such as triangles or triple top patterns and double bottom patterns. Zoom in to see the smaller two and three candlesticks patterns.
The small patterns like shooting star patterns or the white soldiers patterns help to point you in a direction. If you're buying debit spreads you want a bullish pattern to break out.
The opposite is also true. A put debit spread would be placed when price is breaking down.
2. The Process
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. Take our options trading course and advanced options strategies course.
3. Practice Trading Debit Spreads
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.