Debit Spreads Explained

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Debit Spreads

A debit spread is an option spread strategy in which the premiums paid for the long leg(s) of the spread is more than the premiums received from the short leg(s), resulting in funds being debited from the option trader’s account when the position is entered.

The net debit is also the maximum possible loss when implementing the debit spread option strategy.

Vertical Debit Spreads

Bull Debit Spread

The bull call spread is the option strategy to employ when the option trader is bullish on the underlying security and wish to establish a vertical spread on a net debit.

Bear Debit Spread

If instead, the option trader is bearish on the underlying security, a vertical spread can also be established on a net debit by implementing the bear put spread option strategy.

Non-directional Debit Spread Combinations

Spreads can be combined to created multi-legged, debit spread combinations that are used by the option trader who does not know or does not care which way the price of the underlying security is headed but instead, is more interested in betting on the volatility (or lack thereof) of the underlying asset.

Bullish on Volatility

If the option trader expects the price of the underlying security to swing wildly in the near future, he can choose to implement one of the following spread combination strategies on a net debit.

Bearish on Volatility

If instead, the option trader expects the price of the underlying security to remain steady in the near term, he can choose to implement one of the following debit spread combination strategies.

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Debit Spreads Option Strategy

The debit spread strategy is relative popular, easy and common for directional option trading. This defined risk vertical spread strategy is very similar to credit spreads. Differences are the risk profile and the more directional behavior of this spread. There are multiple different ways to set up debit spreads. I will be presenting the two most common ones.

Bull Call Debit Spread

Market Assumption:

When trading a Bull Call Debit Spread you obviously should have a bullish assumption. How bullish you should be depends on how far you go OTM. If you stay very close to the current price of the security, you can just be slightly bullish.

Setup:

  • Buy 1 Call
  • Sell 1 Call (higher strike)

This should result in a Debit (Pay to open)

Profit and Loss:

This can be a very profitable strategy. A Bull Call Debit Spread is a limited risk and limited profit strategy. The max profit is usually much higher than the max loss for debit spreads. Max profit is achieved when the price of the underlying is anywhere above the short strike. Max loss on the other hand occurs when the price is below the long strike. The break-even point is somewhere in between these strikes.

Maximum Profit: Strike of Short Call – Strike of Long Call (Width of Strikes) – Premium Paid – Commissions

Ex. 53 – 50 = 3 (3$ width of strikes) => 3$ *100 – 50$ (Premium Paid) – 5$ (Commission) = 245$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Premium Paid + Commissions

Ex. 50$ (Premium Paid) + 5$ (Commission) = 55$ (max loss)

Implied Volatility and Time Decay:

A Bull Call Debit Spread profits from a rise in implied volatility. This means it is best to use this strategy when IV is rather low (below IV rank 50).

Time Decay or the option Greek Theta works against this position and is therefore negative. Every day the long option loses some of its extrinsic value. The amount of value lost every day increases the closer you get to expiration.

Bear Put Debit Spread

Market Assumption:

As the name implies this is a bearish strategy and therefore your directional assumption should be bearish as well. The further you go OTM with this strategy the more bearish you should be.

Setup:

  • Sell 1 Put
  • Buy 1 Put (higher strike)

This should result in a debit (Pay to open)

Profit and Loss:

A Bear Put Debit Spread is a risk defined and limited profit strategy. The max profit achievable is greater than the max loss. The maximum profit is achieved when the price of the underlying is below the short option strike. The max loss happens when the price is above the long strike. The break-even point is between these two strikes.

Maximum Profit: Strike of Long Put – Strike of Short Put – Premium Paid – Commissions

Ex. 50 – 48 = 2 (2$ width of strikes) => 2$ *100 – 40$ (Premium Paid) – 5$ (Commission) = 155$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Premium Paid + Commissions

Ex. 40$ (Premium Paid) + 5$ (Commission) = 45$ (max loss)

Implied Volatility and Time Decay:

Just as a Bull Call Debit Spread the Bear Put Debit Spread also profits from a rise in implied volatility and therefore should be used in times of low IV (IV rank under 50). Doing this will increase your chances of winning.

The Time Decay or Theta is negative and doesn’t work in the favor of this strategy. The long option will lose some extrinsic value as time passes. It loses value at a faster rate the closer you get to expiration.

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12 Replies to “Debit Spreads Option Strategy”

I am very interested in Options trading and started to study it. I am still very new at it, and still having trouble understanding its complexity mainly due to many terminologies and how Option is priced.

But Options is the safe way to invest (I am not much of a risk taker here comes to the stock market) that you can put the hedge around the risk. I am looking forward to learning more about Options.

If you are interested in learning more about options and how to earn consistent money with them you should definitely check out my education section here.

In the Bear Call and Bull Put Credit Spreads you identified the Break Even Point by a Formula such as: Short Strike – Net Credit or Short Price + Net Credit, Can please provide the formula for the Bull Call and the Bear Put Credit spread.

If possible can you elaborate in each of above strategies (Bull Call & Bear Put) where the profit exist above or below the BEP.

Thanks for your comment Camille.
Here is a list of formulas to calculate the breakeven points of different spreads:
Bear Call spread: Short strike + Credit received (max profit is achieved if the underlying’s price is below the short strike)
Bull Call spread: Long strike – Debit paid (max profit is achieved if the underlying’s price is above the short strike)
Bear Put spread: Long strike + Debit paid (max profit is achieved if the underlying’s price is below the short strike)
Bull Put spread: Short strike – Credit received (max profit is achieved if the underlying’s price is above the short strike)
I hope this helps. Otherwise, please let me know.

Hi Louis,
Do you have any articles on debit call/put adjustments? I am familiar with turning a long into a vertical spread, turning the vertical into a butterfly if the underlying keeps going down or . But, wondering if there is anything different. Thank you.

Sadly, I do currently not really have any articles on option strategy adjustments. But I have written your suggestion down and I will create training on adjustments sometime in the future.

A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price.

Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls.

My question: What I don’t understand is that:

– For a Single short call, if the stock price increases above the strike price, we make a loss. But in the above vertical spread, in fact we gain when the stock price move above the higher strike price of the two calls?

Hi Nicole,
Thanks for your question. A vertical spread consists of two options: a short option and a long option of the same type at a different strike price. For a bull call spread, you buy a call and sell a call at a higher strike price. This means that the long call option will be worth more than the short call option. Because of this, there is a certain price difference between the two options. If the underlying’s price moves above the strike price of the short option, you will be able to take advantage of this price difference because the long option will always be worth more than the short option. In other words, the long option is the dominant one and thus it has more influence on the payoff than the short option. Therefore, a bull call spread is a bullish strategy.
I really hope this helps.

Using this example, wouldn’t you still make money if the underlying goes past your short strike, because the long will gain in value faster than the short loses value if the underlying goes up in price? The long and short can’t be cancelling each other’s gain or loss exactly, correct? I ask because the payoff diagram shows the profit to stop at the short strike.

Hi Tim,
To calculate the break-even point of a bull call spread, you simply add the net cost of the spread to the lower (long) call strike. If the price of the underlying is anywhere above this price at expiration, the position will achieve a profit and vice versa. It is at this point that the long call’s gain and short call’s loss cancel each out exactly. Above it, the long call is worth more and below it the short call has a bigger loss.
I hope this answers the question. Otherwise, let me know.

Thanks for the super fast response. I think the only thing that I’m still confused with is the 1.) max profit calculation and 2.) the profit loss diagram.

1.) Max profit – your article states that Max profit = Strike of Short Call – Strike of Long Call (Width of Strikes) – Premium Paid – Commissions. This calculation makes sense if we are expecting to exercise both positions, or in other words calculating the instrinsic values. This calculation is not necessarily what the profit/loss would look like if we were just trading contracts due to option prices being different from stock prices, correct?

2.) Profit/Loss diagram makes sense if it is showing instrinsic value only.

Hi Tim,
The profit and loss diagram and the max profit/loss calculations are for the price of the position at expiration. So you are correct that they only show intrinsic value. At expiration, there is no extrinsic value left (because there is no time left till expiration). The blue line in the profit/loss diagram shows how the P&L looks sometime before the expiration date.
The formula to calculate P&L before expiration is much more complicated as you have to take many other market variables into account. If you are interested in such a formula, I recommend checking out my article on the black scholes formula.
If you have any other questions or comments left, please let me know.

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Debit Spread

What Is a Debit Spread?

A debit spread, or a net debit spread, is an option strategy involving the simultaneous buying and selling of options of the same class with different prices requiring a net outflow of cash. The result is a net debit to the trading account. Here, the sum of all options sold is lower than the sum of all options purchased, therefore the trader must put up money to begin the trade.

The higher the debit spread, the greater the initial cash outflow the trader incurs on the transaction.

How a Debit Spread Works

Spread strategies in options trading typically involve buying one option and selling another of the same class on the same underlying security with a different strike price or a different expiration.

However, many types of spreads involve three or more options but the concept is the same. If the income collected from all options sold results in a lower money value than the cost of all options purchased, the result is a net debit to the account, hence the name debit spread.

The converse is true for credit spreads. Here, the value of all options sold is greater than the value of all options purchased so the result is a net credit to the account. In a sense, the market pays you to put on the trade.

Example of a Debit Spread

For example, assume that a trader buys a call option for $2.65. At the same time, the trader sells another call option on the same underlying security with a higher strike price for $2.50. This is called a bull call spread. The debit is $0.15, which results in a net cost of $15 ($0.15 * 100) to begin the spread trade.

Although there is an initial outlay on the transaction, the trader believes that the underlying security will rise modestly in price, making the purchased option more valuable in the future. The best case scenario happens when the security expires at or above the strike of the option sold. This give the trader the maximum amount of profit possible while limiting risk.

The opposite trade, called a bear put spread, also buys the more expensive option (a put with a higher strike price) while selling the less expensive option (the put with a lower strike price). Again, there is a net debit to the account to begin the trade.

Profit Calculations

The breakeven point for bullish (call) debit spreads using only two options of the same class and expiration is the lower strike (purchased) plus the net debit (total paid for the spread). For bearish (put) debit spreads, the breakeven point is calculated by taking the higher strike (purchased) and subtracting the net debit (total for the spread).

For a bullish call spread with the underlying security trading at $65, here’s an example:

Buy the $60 call and sell the $70 call (same expiration) for a net debit of $6.00. The breakeven point is $66.00, which is the lower strike (60) + the net debit (6) = 66.

Maximum profit occurs with the underlying expiring at or above the higher strike price. Assuming the stock expired at $70, that would be $70 – $60 – $6 = $4.00, or $400 per contract.

Maximum loss is limited to the net debit paid.

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