A debit spread is an options strategy that involves the purchase and sale of the same class of options with the same expiration date but different strike prices. Right now, this may sound confusing, but let’s break down the call debit spread in simple terms. The call option you purchase is just a bullish bet on a stock moving up. To reduce the amount you pay for this call, you go to a cheaper option with the same expiration date and sell this option. Doing this will turn your call option into a debit spread and give you a defined risk-to-reward.
What Is a Call Debit Spread? What Is a Vertical Call Spread?
A vertical call spread, also known as a call debit spread, is a bullish options trade with a max profit and loss defined upon entering. You can construct a call debit spread by purchasing a call option and selling another call option against it with a higher strike price within the same expiration date. This trade will result in you paying a net debit to open it since the call you buy will be more expensive than the one you sell.
Call debit spreads are an efficient way to speculate on a stock moving up in the short term. You can open a call debit spread on high-priced stocks for as little as $100 in buying power. The buying power efficiency of debit spreads allows traders with smaller accounts to trade high-priced stocks on the market effectively.
How to Trade Out-of-the-Money Vertical Call Spreads
A call option is considered out-of-the-money (OTM) when its strike price is above the current stock price. Traders can buy OTM calls if they believe a stock will move up significantly in the near future. Buying a call option is cheaper than buying 100 shares of a stock and can provide a higher reward potential. However, it is possible to lose all your investment buying call options if they expire before the stock goes above your strike price.
The higher the strike price of a call option, the further out of the money the option is. Far OTM calls have a low chance of profiting but can provide fantastic profit potential if you are right. Since the probability of profit is so low, far OTM call options are cheap to purchase.
Traders may prefer to buy a call debit spread instead of a single call option to increase their probability of profit. You simply sell a higher strike call option within the same expiration to turn a single long call option into a debit spread. The benefit of trading a call debit spread over a single call is that the call you sell finances some of the cost of the single call. However, a downside to call debit spreads is they limit the amount of profit you can make. A single call option technically has unlimited profit potential, but a call debit spread comes with a defined max profit and max loss.
A Simple Example of a Vertical Call Spread
Analyzing an example of a call debit spread or vertical call spread can help you better grasp the concept. Let’s say that stock XYZ is trading at $100 per share, and you believe it will go above $110 per share soon. The following is an example of a call debit spread you can purchase.
Buy-to-open 105-strike call @1.00
Sell-to-open 115-strike call @0.50
Total debit: 0.50 ($50)
In this example, the long 105-strike call you purchased will turn a profit if XYZ stock goes above 105. Since the 105-strike call is more expensive than the 115-strike call, you paid a debit to open the trade. However, because you simultaneously sold a 115-strike call for $0.50, you only had to pay $0.50 to open this trade instead of the total $1.00 of the single 105-strike call option. You can technically win on both ends of this trade if the stock expires at 110 per share at expiration. If the stock is at 110 at expiration, then the 115 call will expire worthless, and the 105 call will be worth $5.
Schaeffer's Vertical Options Trader
To learn more about options trading, sign up for our new Vertical Options Trader newsletter! Schaeffer’s Vertical Options Trader trades front-month and out-of-the-money vertical spreads (aka debit spreads). Verticals are an important strategy that every options trader should have in their arsenal. Out-of-the-money options offer the greatest leveraged gains, and verticals are the smart way to play them. Verticals are the perfect strategy for trading options involving the most volatile stocks in the marketplace. Click here for more information!
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