A debit spread is a type of options trading strategy that consists of simultaneously buying and selling options with the same underlying asset, but different strike prices, requiring a net outflow of cash for the investor. Since a trader is paying a premium to open those positions, they need to put down money up front. That creates the “debit” in their account, which is why it’s called a debit spread.
Debit spreads can be constructed using calls or puts, depending on whether the trader is bullish or bearish, and can be created with a wide or narrow spread, depending on the trader’s risk tolerance. With that said, here is what you need to know about the basics of debit spreads and some key factors to consider if you are going to trade one.
Debit Spread Defined
In the simplest terms, a spread refers to a strategy where a trader is selling and buying an option at the same time. With a debit spread, the cost of options sold is less than the sum of options purchased, so the investor must put up money to begin the trade. The result is that the trader receives a debit to their trading account. Just as there is a range of options spreads, there are numerous types of debit spreads. The main goal of utilizing them is to incorporate more than one option transaction pegged to the same underlying asset in an effort to create a defined range for downside risk and potential profit.
A debit spread is the opposite of a credit spread, which results in a trader having a credit in their trading account, and they’re both types of vertical options spreads. That means that traders can take volatility into account when trying to decide if they should make a bullish or bearish strategy when buying options.
How Debit Spreads Work
As mentioned, the gist of a debit spread is that a trader buys and sells two (but sometimes more) options simultaneously. The two options are pegged to the same underlying asset (a stock, for example), but they have a different strike price. That underlying asset can be a stock, or even an index — which is why we have index options on the market, too.
A debit spread is a directional trade, which means it is a bet on the market going either up or down. So whether a debit spread is ultimately profitable will primarily depend on whether the underlying asset moved up or down in favor of the trade. However, there are a few additional factors that tend to impact how the trade will play out.
For one, debit spreads, like long options strategies, will suffer from time decay. This means that they will lose value as time passes if other factors (like the underlying asset price) remain constant.
Debit spreads will also feel an effect from changes in the level of volatility in the underlying asset. If volatility falls, then so will the value of the spread. This impact is typically limited, but if implied volatility is high when the debit spread is purchased, then the trade could be vulnerable to a sharp drop in volatility.
Debit Call Spread vs Debit Put Spread
Debit spreads can utilize different types of options contracts — calls as well as puts. That gives us two types of debit spreads: Debit call spreads, and debit put spreads.
Debit Call Spread
As you may have surmised, a debit call spread is a type of debit spread that may also be referred to as a “bull call spread.” Call debit spreads, or bull call spreads, are utilized when a trader has a bullish assumption. That is, they believe that an asset’s price will rise, and they create an option spread in order to capitalize on that.
Debit Put Spread
A debit put spread — also called a put debit spread, or bear put spread — is the inverse of a debit call spread. A trader is making the assumption that a security or asset’s value will decline in the future, and opens up a spread — using the correlated options purchases — in order to take advantage of that decline in value.
Here’s a brief look at how the two compare:
|Debit Call Spreads||Debit Put Spreads|
|Traders are bullish on underlying asset||Traders are bearish on underlying asset|
|Involves purchases two calls||Involves purchasing two puts|
|Traders buy one call, sell another at a higher strike price||Traders buy one put, sell another at a lower strike price|
Debit Spread Example
A trader is bullish on Stock X. The trader expects the stock to move moderately upward in the near term, and wants to limit their downside risk, so they decide to open a debit spread position. As such, they’ll need to purchase two call options at the same time, both at different strike prices, but both pegged to Stock X and with the same expiration dates.
Stock X is currently valued at $50. The trader may buy a call option with a strike price of $50, and pays a premium of $3 for doing so. The trader also sells another call option at a different, higher strike price (remember, our trader is bullish!) of $55, and is credited a $1 premium for the sale.
That opens up a bull call spread, from $50 to $55. The total cost of opening the spread is $2, since it cost $3 to buy one call, and there was a credit of $1 for selling the other. That total cost now is also the maximum potential loss that can result from the trade — the trader has effectively capped their risk. But they’ve capped their reward, too: once the stock goes above $55, it will cease to gain additional profit.
And to calculate maximum profits and break even points? From the above example, the maximum potential profit appears to be $5, which amounts to the differences between the strike prices in the spread. But, when taking the cost of premiums into account, along with the gain on the spread, the maximum potential profit is $3.
And to calculate the breakeven point, the trader would take the lower of the two strike prices, and add the debit, or premium paid for the spread.
Other Debit Spreads
Spreads come in a variety of types — bullish and bearish, puts and calls, debits and credits, and so on. We won’t get into all of them, but it can be useful to know that other debit spreads are out there. Some examples are bear call spreads and bull put spreads, which are more or less the opposite of those we’ve discussed. But there’s also the entire other side of the credit/debit spread coin: Credit spreads. Again, we won’t get into those here, but being aware of them is another step towards learning more options strategies.
This guide to options spread strategies can also shed more light on credit vs. debit spread divide.
The gist of a debit spread is that a trader buys and sells two (but sometimes more) options simultaneously. The two options are pegged to the same underlying asset (a stock, for example), but they have a different strike price. Depending on how the trader feels things on the market will play out — that is, whether they’re bullish or bearish — buying the two options creates a spread. If they’re bullish, they’ll buy a call with a certain strike price, and sell another simultaneously with a higher strike price. This creates the “spread” between the two strike prices, and caps the maximum risk of the trade at the premium paid to buy the options.
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