What Are Debit Spreads?

Subtitle

Bull Call | Bear Put
What Are Debit Spreads?

Learn how to set up and profit from debit spread options

  • FYI- Would rather use strategies that sell premium rather than using debit spreads
  • Set up in low volatility environments
  • Straddle the stock price
  • Buy an ITM option and Sell an equidistant or slightly closer OTM option
  • Set up so that the break even is just around the stock price or ideally even just a little bit better
  • Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success

Checklist order

  • Check to make sure volatility is high 
  • Straddle ( then skew if wanted ) the stock price
  • Buy an ITM option and sell an equidistant OTM option
  • Check the premium debit 
  • Calculate the break even price based on the debit
  • Make sure the BE is just around and ideally slightly better than the premium ( premium less than BE for put debit spreads and greater than BE for call debit spreads )

You will ideally want to set up a debit spread so that the break even price is just around the stock price.  The break even price is determined by the spread width and the debit premium.

If the break even is just around the stock price, then it is possible that you break even or profit even if the stock price does not move.

If you have a 10 strike wide 95-105 call debit spread and the stock price is 100 ( in the middle ) the profit on the option is potentially 5 dollars ( 100 minus 95 ).  You will want to collect a premium of about 5 dollars.

Checklist order

  • Check to make sure volatility is high 
  • Straddle ( then skew if wanted ) the stock price
  • Buy an ITM option and sell an equidistant OTM option
  • Check the premium debit 
  • Calculate the break even price based on the debit
  • Make sure the BE is just around and ideally slightly better than the premium ( premium less than BE for put debit spreads and greater than BE for call debit spreads )

 

If the stock price does not move at all, the short strike will expire worthless.  

The long call, however, will be worth about 5 dollars (  100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.

If the stock moves in your favor and moves above the short strike, you will achieve maximum profit.  The maximum profit is calculated by the width of the strikes minus the debit you paid.

In this example, the width is 10 and the debit it 5.  So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.

If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade.  Maximum loss is simply the price of your debit premium.  In this case it is 5 dollars.

You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.  

Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread.

If the original debit was 5 dollars and you were able to get another 30 cents.  Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.

If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed.  Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide.  Your profit is based now on a strike width of 5 minus the debit which is now 4.7.

 

If the stock price does not move at all, the short strike will expire worthless.  

The long call, however, will be worth about 5 dollars (  100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.

You might not want to manage this trade if you are  at least breaking even,  It might be hard to move the short strike down for a credit and it might be harder to move it down and still pay for the expense of commissions.  This scenario will depend on whether or not you can move it down for a reasonable credit.  

Intro Paragraph

Checklist considerations

  • this management strategy at least will decrease the cost basis and maximum loss
  • If we roll the option for a debit, we will take on extra risk and possibly lock ourselves into a bigger loss
 

 

An options spread is an options strategy involving the purchase AND sale of an option at different strike prices OR different expiration dates.

All options spread are set up as the same type.  They are either all call options or all put options and on the same underlying asset

They differ in only the expiration date or the strike price.

They are set up with the same number of buy options as sell options.  If you buy 5 call options, you will also sell 5 call options.

A bullish long call diagonal spread is set up by

  • vertical spreads
  • horizontal spreads
  • diagonal spreads
 

 

Vertical spreads are options that differ only in terms of strike price.  They will have the same expiration and are of the same type ( all calls or all puts )

  • call spreads
  • put spreads
  • —————-
  • bull spreads
  • bear spreads
  • —————-
  • credit spreads
  • debit spreads

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Buying a Call

What is the difference between a put and call credit spreads?

  • The maximum profit for credit spreads ( bull and call ) is the premium collected
  • The maximum loss for credit spreads ( bull and call ) is the width of the strikes
  • Iron condors are created by combining a bull put credit spread and a bear call credit spread
  • Both are defined risk strategies

Bull Put Credit Spreads – 

  • Set up by selling a short put at a higher strike price while buying a long put at a lower strike price
  • The width of the strikes will define your risk
  • The premium collected is your maximum profit
  • You will profit as long as the price of the stock is greater than the short strike plus your premium collected. 

Bear Call Debit Spreads – 

  • Set up by selling a short call at a lower strike price while buying a long call at a higher strike price
  • The width of the strikes will define your risk
  • The premium collected is your maximum profit
  • You will profit as long as the price of the stock is less than the short strike minus your premium collected. 

Iron Condor – 

  • Notice that when you combine a bull put spread and a bear call spread, you get the pay-off diagram for an iron condor.

The Greeks

How Does a Credit Spread Change with Volatility and Time

The short option is generally closer to ATM than the long option and is therefore mostly a SHORT option strategy:

  • The short option exhibits the dominant behavior with respect to time and volatility for a credit spread
  • Short options benefit from the passage of time
  • Short options benefit from a drop in volatility
  • Short options should be written in periods of high implied volatility
  •  Delta – Delta represents the change in an option price for every 1 dollar move in the underlying stock.  A short put benefits  from a move up in the stock price ( positive value ) .  A short call benefits from a move down in the stock price( negative value )
  • Negative Gamma – Gamma represents the rate of change in delta.  A large gamma means that Delta is changing very rapidly.  And the option price will lose more and more value for every dollar move in the wrong direction while the profit for every 1 dollar move in the right direction will become smaller and smaller.  Gamma will increase the closer you are to expiration.  Therefore you, the option will lose more value faster as you reach expiration
  • Positive Theta – Credit spreads benefit from the passage of time.  Both have positive Theta.  The positive value of Theta ( for short options ) accelerates as you approach expiration.  
  • Negative Vega – Short options benefit from drops in implied volatility.  Vega represents the change in an option price for a change in implied volatility.  The value of both call and put credit spread options value will decrease with a increase in implied volatility. And vis versa.

Buying a Call

Profit and Loss Chart

  • Max Profit Potential: (Call Spread Width – Net Debit Paid) x 100
  • Max Loss Potential: Net Debit Paid x 100
  • Expiration Breakeven: Long Call Strike + Net Debit Paid

Position After Expiration:


  • If the long and short call are both in-the-money at expiration, the assignments offset, resulting in no stock position. 
  • If only the long call is in-the-money at expiration, the resulting position is +100 shares of stock per call contract.
 
Assignment Risk:

  • When the short call of a bull call spread is in-the-money, a bull call spread trader is at risk of being assigned -100 shares of stock per short call contract.
  • The probability of being assigned on short calls is higher when the short call has little extrinsic value.
  • Alternatively, short call assignments are common before a stock’s ex-dividend date, primarily when the dividend is greater than the short call’s extrinsic value.

Credit Spreads

  • Max Profit= premium
  • Maximum Risk = ( width of the strikes – premium )

Debit Spreads

  • Max Profit= ( width of the strikes – premium )
  • Maximum Risk = premium

Vertical Spreads

How Do You Set Up a Vertical Spread?

Bear Call Spread ( credit spread )

  • sell a call at lower strike while buying a call at a higher strike
Bull Call Spread ( debit spread )
  • buy a call at a lower strike while sell a call at a higher strike

Bull Put Spread ( credit spread )

  • Sell a call at a higher strike while buying a put at a lower strike

Bear Put Spread ( debit spread )

  • Buy a put at a higher strike while selling a put a a lower strike

Option Basics

Tips and Tricks

A call option will benefit from :

  • A rise in stock prices
  • A rise in volatility
  • An early rise in stock price ( time kills the stock value )

Checklist order

  • Check to make sure volatility is high 
  • Straddle ( then skew if wanted ) the stock price
  • Buy an ITM option and sell an equidistant OTM option
  • Check the premium debit 
  • Calculate the break even price based on the debit
  • Make sure the BE is just around and ideally slightly better than the premium ( premium less than BE for put debit spreads and greater than BE for call debit spreads )
  • FYI- Would rather use strategies that sell premium rather than using debit spreads
  • Set up in low volatility environments
  • Straddle the stock price
  • Buy an ITM option and Sell an equidistant or slightly closer OTM option
  • Set up so that the break even is just around the stock price or ideally even just a little bit better
  • Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success

Buying a Call

Management and Adjustments

  • Maximum Profit Potential: Unlimited
  • Maximum Loss Potential: Premium Paid for the Call
  • Expiration Breakeven Price: Call Strike + Premium Paid for Call
  • Estimated Probability of Profit: Less Than 50%
  • Assignment Risk?

Setting Up a Debit Spread

FYI- Would rather use strategies that sell premium rather than using debit spreads

Set up in low volatility environments

Straddle the stock price

Buy an ITM option and Sell an equidistant or slightly closer OTM option

Set up so that the break even is just around the stock price or ideally even just a little bit better

Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success



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