What Are Put Debit Spreads & How to Trade Them?
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%. Watch our video on how to trade put debit spreads.
What Are Put Debit Spreads and How to Trade Them?
Put debit spreads are a bearish options strategy that limits your trading risk. It consists of buying a long put and short put strike with the same expiration date. The short put reduces the theta and delta of your contract. Buy a put and sell a put.
Put debit spreads are a bearish trading strategy. Watch our video on how to trade a put debit spread.
Hence the appeal of options. However, options are much more involved than stocks. Therefore, the ability to lose or profit is much higher.
That means study and practice are essential to becoming a successful options trader. We’ve got you covered!
A put debit spread is a bearish options trading strategy with limited risk. Like other options spreads, they limit risk. However, the trade-off with limited risk is limited profit. We can’t have it both ways; that’s life, I suppose.
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.
Key Takeaways of Put Debit Spreads
- 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.
Let’s Build the Spread!
It’s straightforward; to deploy put debit spreads you:
- Buy 1 put
- Sell 1 put
- With a strike price further away from the strike price of the put 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).
A Real Life 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.
Check out our trading service to learn more about put debit spreads and how to trade them.
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. Check out our swing trading room to see live examples of put debit spreads along with other trading strategies.
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. Take our advanced options strategies course.
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.
Make Sure to Practice
Trading is emotional. Greed and fear are the foundation of moving markets. Put debit spreads help to protect you from those emotions.
However, you can sometimes stay in a position because you want more money. We’ve all been there. That tends to be when we blow up our accounts or go from a winning trade to a losing one.
Yes, spreads can the profit even with the cap. That’s why trading them in conjunction with other strategies is good. However, it’s important to practice before using real money.
That way you’re able to work out the kinks and see how the Greeks and implied volatility affect your trades. You can work out the best entries and exits as well as the length of a trade.
Then you when you go to use real money, you have a plan. Remember, plan your trade and trade your plan. Deviating from your plan always spells trouble.
Take our online trading courses to learn different trading strategies as well as trading options.
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.
If you want to learn more and have no idea what you need to be doing, Bullish Bears is just the right place for you to launch your trading career.
Not only will we help you to succeed, but we will also help you avoid spending unnecessary money on expensive education programs. We keep it simple, easy to understand, and affordable.