Debit Spreads Explained

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Contents

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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As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

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Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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.

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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Bull Call Debit Spread Explained

A bull call spread is a vertical spread that relies on two calls with the different strike prices and same expiration date.

The strike price of the short call is higher than the strike price of the long call, which means this strategy is a debit spread, but the short call option can be utilized to offset some of the cost for the more expensive call that was purchased.

The main difference between buying a straight call option in comparison to initiating a debit call spread is the limited upside profit potential that the spread provides, in return for less risk upfront.

Up to a certain price, the bull call spread works similarly to its long call component would as a standalone strategy.

However, the upside potential is limited to the lower strike price that was sold to bring in additional premium.

That’s the main trade-off; the short call premium reduces the overall cost of the strategy but also sets a ceiling on the profit potential of the trade.

The maximum loss when utilizing the debit call spread is limited to the cost of the spread; in the worst case scenario, the asset will expire at a price that’s below the strike price of the lower prices strike price, the option that was purchased, in that case both options would expire worthless.

The best case scenario would be for the price of the asset to expire at or immediately the strike price that was sold, this way the option that was purchased would expire in the money, while the option that was sold would expire at the money or slightly out of the money, either scenario would yield no profit on the short position, while maximizing gains on the more expensive call that was purchased.

Break-even = long call strike + net debit paid

This strategy breaks even at expiration if the asset’s price is above the lower strike by the amount of the initial cost of the spread. In that case, the short call would expire worthless and the long call’s intrinsic value would equal the debit.

Time is not in favor of the buyer when it comes to debit spreads and the credit bull spread is no exception and hurts the position, though not as much as it does a plain long call position. Since the strategy involves being long one call and short another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.

Assignment Risk With Stocks

If you trade stock options, you run the risk of early assignment, while possible at any time, it generally occurs only when the stock is very close to expiration and is trading in the money, otherwise the risk of early assignment is relatively low.

Decrease your risk of early assignment by offsetting positions before they get too close to expiration or the strike price of the option that you sold begins trading in the money.

When to Utilize Call Debit Bull Spreads

Because the upside profit potential is capped to the difference between the strike price that was purchased and sold, the best time to initiate a call debit bull spread, is when you are expecting a mild to moderate price gain in the underlying asset.

If you are expecting a major momentum price move, within relatively short time, it makes more sense to purchase a net long call option; to leverage the maximum gain or profit potential of the underlying asset.

But unless you trading stocks during earnings season, it’s very hard to anticipate with any degree of certainty, the degree of the projected price move in the underlying asset and because stocks trend only about 20% to 30% of the time on average, it makes more sense to initiate debit spreads, instead of net long positions the great majority of the time.

When initiating and liquidating the call debit bull spread, it’s always best to place the order as a spread instead of “legging” into the spread one position at time.

My advice is to utilize limit orders and adjust your bid every 30 minutes throughout the day till you get a price fill.

When you trade both sides of the spread as one order, you will find that your trade fills are generally better about 75% of the time.

Lastly, make sure to trade options that are based on assets with high liquidity levels.

Option liquidity always substantially lower than the underlying asset; you will find that liquidity levels can be surprisingly low, which can lead to very wide spreads between the bid and offer; that could lead to less than fair price fills.

So consider trading options that are based on underlying stocks that have higher than average daily average volume, over the past few months, to ensure that your price fill when initiating and liquidating the spread is fair.

Option Credit Spreads Explained

Vertical Credit Spreads are probably the most used option trading strategy out there (especially for high probability options trading). The strategy is very simple to do and only requires a long and a short option contract at different strikes. The Premium received is higher than the amount paid for the long legs, therefore resulting in a net credit. In this article, you will learn everything you need to know about credit spreads.

If you aren’t familiar with options spreads in general, make sure to check out my options spreads article first.

Video Breakdown:

Bull Put Credit Spreads

Market Assumption:

Just like the name indicates this is a bullish strategy. So you should have somewhat of a bullish outlook when trading a Bull Credit Spread. But as you’ll see in the profit and loss section/diagram the price can also stay the same or even move a little against you. So you can also just be very slightly bullish. Depending on how far you go OTM the price can even move down a lot while you still make money. This defined risk strategy is often used for high probability options selling.

Setup:

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

This should result in a credit (You get paid to open)

Profit and Loss:

A Bull Put Credit Spread is both limited risk and limited profit. There is a set maximum loss and profit defined before entry. The max loss is bigger than the max profit. Maximum profit is achieved as long as the price stays above the strike of the short position. Maximum loss happens when the price is below the long strike. The long position acts as a hedge and makes this a defined risk trade.

Maximum Profit: Premium received – Commissions

Ex. $20 Premium – $3 = $17 (max profit)

Maximum Loss: Width of Strikes * 100 – Premium received + Commissions

Ex. (Strike 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max loss)

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

Implied Volatility and Time Decay:

Bull Put Credit Spreads profits from a drop in Implied Volatility. This means it is best to use this strategy when IV is high (IV rank over 50) because you then have a higher chance of making money.

Time Decay or Theta works in favor of this strategy and is therefore positive. The more time goes by, the more value the sold option contract loses which is good for this strategy. The closer to expiration, the more time decay there is daily.

Bear Call Credit Spread

Market Assumption:

A Bear Call Credit Spread is best used for bearish or almost neutral conditions. It gives the holder a cushion for the price to move. The price, therefore, has quite a lot of room to move in where this strategy still is profitable. This defined risk strategy is often used for high probability options selling.

Setup:

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

This should result in a credit (You get paid to open)

Profit and Loss:

Just like Bull Put Credit Spreads the Bear Call Credit Spread also is a defined risk and defined profit strategy. The maximum profit is reached as long as the price of the underlying stays lower than the strike of the short position. The maximum loss occurs when the price is higher than the long strike. The max loss is bigger than the max profit. The long contract acts as a hedge to make the risk of this strategy limited.

Maximum Profit: Premium received – Commissions

Ex. $20 Premium – $3 = $17 (max profit)

Maximum Loss: Width of Strikes * 100 – Premium received + Commissions

Ex. (Strike 50 and 52) => $2 Width * 100 – $20 Premium + $3 Commissions = $183 (max loss)

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

Implied Volatility and Time Decay:

A Bear Call Credit Spread also profits from a drop in Implied Volatility and therefore also should be sold when there is high IV (IV rank over 50). This will increase the chances of winning with this strategy.

Time decay works positively for this setup. Every day the value of the sold option loses some of its extrinsic value and therefore increases your chances of keeping the full premium.

Trader’s Note:

Credit Spreads are a very good, easy and versatile option strategy. In fact, they are my favorite and most used strategy up to this point. If they are used correctly, they can be very profitable. Credit spreads are one of the best strategies for high probability trading. I would recommend trading credit spreads only with OTM strikes and with a rather high probability of profit. If this is done, the price will have space to move in. The further the strikes are OTM, the higher the probability of profit becomes. Additionally, the max profit decreases and the max loss increases. Too far OTM strikes will result in very small credits and very high max losses. Therefore these should be avoided.

How To Set Up Credit Spreads In A Broker Platform:

8 Replies to “Option Credit Spreads Explained”

I find this idea very interesting, but you`ll have to forgive me, what exactly would I be putting a trade on? Stocks/Shares? Oil/gas or other items of value?

Anyway, The idea sounds to be a bit like “matched betting” whereby you put two opposing bets on, and get a net profit. Would that be a fair assumption?

I lookforward to your reply.

Well this is a very common options strategy. It seems to me that you are quite new to options and don’t have a complete understanding of them. To understand this strategy and options in general better check out my free education section HERE.

Hey Buddy! My name is Brad and I am an experienced FOREX trader. I thoroughly enjoyed your information on technical analysis and it seems like you represent yourself as a true chartist. However, my question for you would be how does the fundamental analysis of market action affect your theories? The chart reacts to the news in most sizable trends and the news can be a very good indicator of what the chart will do. Case in point, the EUR/USD has been rising a lot lately (ALTHOUGH IT SHORTED TODAY) and I recognize the political happenings in Washington as the prime indicator of these uptrends. I don’t hate the man, but every time the President opens his mouth the dollar weakens. Especially with the hearings taking place every week. It seems as though the news has something to do with the fluctuation of the markets. I do know that when the Fed increases interest rates a huge USD trend usually follows.

The only problem with fundamental analysis however is that we usually gain access to the news after it is too late. How do you remedy this problem?

Hey Brad,
First of all thanks for your comment. To be honest I don’t really believe too much in fundamental analysis. Of course events like elections, referendums, increases in interest rates, announcements etc. will have impacts on the market. But I don’t really believe that the core ideas behind fundamental (reading balance sheets, cash flow statements and more) deliver any kind of edge for traders. Everybody has acces to these and it’s is nearly impossible to find anything new, which no one else has found before. Therefore I do not use fundamental analysis in my trading. Of course I always check what news/events lay ahead (for example: earnings, dividends announcements of the Fed, elections…), but I don’t really trade based on any of these events. I usually just try to avoid some of them. I don’t buy or sell a certain option, based on my findings through fundamental analysis. It is almost important to have a good market awareness (you can find more on that here) and know what will impact your position, but my option trading style really does not rely on any forms of fundamental analysis at all (neither on technical analysis). It is based on the historical overestimation of implied volatility. Basically I sell out of the money options, which expire worthless most of the time. To learn more about my strategy check out my education section (here)

But I do know that things are quite different in Forex. Currencies are much more sensitive to market news and events. But I never really have traded any Currencies before, so I can’t speak too much for that.
I hope this could help you a little. If you have any further questions or comments I would be happy to hear more from you.

Hi, I am interested in credit spreads. It seems you have to have a substantial amount of money in your account to achieve a decent profit. For example, how much would you have to have in your account to produce 5K each month? Also,, is there software that can help with this?
Thanks.

Hey Judith,
Well your profit really depends on your trading style and risk tolerance. A 5K profit per month can be done with many different account sizes. So I am sorry, but I cannot really give you a clear answer to your question. But it is safe to say that you cannot consistently earn 5K a month with a small trading account. If you want you can contact me personally here and send me some more details and I will try to help you a little better.

Hi if I have call debit spread. The stock is trading $247 and my spread strikes are $253 and $254. I understand that I will not loss money unless the stock price moves to the $253 price. The goal is the option expires worthless and I get the credit. My question if the stock starts to move against me right-away on the first day of the trade to $252, what happens if I sell right-away or before expiration? Do I make anything? Thank You Tom

Hi Tom,
Thanks for the question. I believe you were referring to a call credit spread, not a call debit spread. A call debit spread with your strikes would mean that you buy the 253 strike and sell the 254 strike. This would mean that the underlying’s price would have to move above 253-254 for you to achieve a profit at expiration.

If you would sell the 253 call and buy the 254 call, it would be a call credit spread which is a bearish strategy. The breakeven point for this strategy would be somewhere between 253 and 254. The effect of an immediate move against you really depends on the position and the underlying asset. However, generally speaking, you probably would have a relatively small paper loss. So if you close the position then, it would likely be at a loss.
However, like I said, this depends on the position. If you, for instance, had a credit spread with a high negative Vega, you might have no loss or even a profit after such an up-move because implied volatility tends to drop when prices go up.

What you could do (if you have a tastyworks account) is to go to the analysis tab. There you can analyze the payoff diagram of such a spread at and before expiration.
I hope this helps.

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