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 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.
Example of a Debit Spread
Let’s say stock XYZ is trading at $100 per share. You are bullish on this stock and expect it to increase to $120 per share within one year. Let’s go over how you could use a call debit spread to take advantage of an increase in the share price:
Buy one $100-strike call for $1.00 and sell one $110-strike call for -$0.50.
You would simultaneously pay a net debit of $0.50 for this debit spread.
If you only bought the $100-strike call, you would need to pay the full $1.00. Since you decided to use a debit spread, you reduced the cost of this trade by a whole $0.50 allowing yourself to keep more buying power on hand. The downside of this setup is that you have removed your ability to make an unlimited amount of profit. If stock XYZ continues to $120 per share, you will miss out on a good chunk of profits because you sold the $110 call and capped the profit potential of the position.
How to Calculate Max Profit and Max Loss of Debit Spreads
The maximum potential profit of a debit spread is equal to the width of the strikes minus the debit paid.
The maximum profit potential for the above example is as follows: $10 - $0.50 = $9.50
The maximum loss potential of a debit spread is equal to the debit paid.
The maximum potential loss for the above example is as follows: $0.50
Debit spreads are defined risk trades meaning that you always know your max profit and max loss for each trade. This is psychologically great because you are taking on less risk than buying naked options. The downside of reducing risk is, of course, a reduction in your potential reward. When buying a call option, you have unlimited upside profit potential. With a debit spread, your maximum profit is capped once the share price reaches the strike of the option that you sold.
When Should You Use Debit Spreads?
Debit spreads are primarily useful for traders with smaller accounts or used in an effort to limit downside potential on an options trade. Keep in mind that if you already have purchased an option in your trading account, you can turn it into a debit spread. This is especially helpful if you are already profiting on your current options position. For example, let’s say you were long the $100 call in our example and the underlying stock increased to $110. That call option went from $1.00 to $11.00. Now, you can go and sell the $110 call to complete the debit spread and, because the price of the stock is higher, this option is now worth $1.00. Let’s break down what would happen if you sold that call now:
Buy one $100-strike call for $1.00, which is now worth $11.00.
Then sell one $110-strike call for $1.00.
So, your initial debit paid for the first call option was $1.00. You then sold the $100 strike call later for a credit of $1.00 after the stock increased in price. This means that you have turned this long call into a practically risk-free debit spread. You paid $1.00 debit and then received $1.00 in credit meaning your cost basis for the spread is $0. The downside of this approach is that, instead of taking your massive profits, you have instead locked in a risk-free play. If the stock were to fall back below $100 per share again you would lose all of your profits at expiration. You should also keep in mind that this method requires a great deal of talent in timing the market which is not easy to do.
Takeaway Tips for Trading Debit Spreads
Debit spreads can be a great strategy to keep in your options strategy toolbox, especially for those with smaller accounts. Stocks that have a higher share price can be costly to trade options on, so the use of option debit spreads can allow any account size to trade these stocks. It can also be helpful to know that you can leg into debit spreads opportunistically to give yourself a better risk/reward ratio rather than just opening the two options at the same time. If you are already in profit on a long call or put option, you can consider reducing your risk to potentially even $0 by selling an option with a different strike price.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
