Debit Spreads

Learn about what Debit Spreads are in options trading and its advantages and limitations.

Debit Spreads - Definition

Debit Spreads are options positions created by buying more expensive options contracts and simultaneously writing cheaper options contracts.

Debit Spreads - Introduction

Debit Spread is one of the two kinds of options spreads, the other being the Credit Spread. Debit spreads are usually the first kinds of options spreads that beginners to options strategies use. Debit spreads not only has predictable maximum loss, making it safer in terms of money management, but it also requires a much lower options account trading level than the more complex credit spreads.

This tutorial shall explore in depth what debit spreads are, how they work and briefly introduce the different kinds debit spread options strategies.

What are Debit Spreads?

Debit spreads refers to options spreads that you have to pay a "net debit" in order to put on, this debit to your account is why such options spreads are known as "Debit Spreads". This means that the short legs in a debit spread do not generate enough premium to offset the price of the long legs, as such, you end up paying money to own such an options position. Options spreads that does the opposite of crediting your account with cash instead are known as "Credit Spreads". This means that you need to pay cash to put on a debit spread while you will actually receive cash for putting on a credit spread.

A simple common example of a debit spread is the Bull Call Spread which consists of buying at the money or in the money call options and then writing out of the money call options at a higher strike price in order to partially offset the cost of owning the long call options.

Debit Spread Example Assuming QQQ is trading at $61, its Mar $61 call options are trading at $0.60 and its Mar $62 Calls are trading at $0.20. Instead of buying only the Mar $61 call options for $0.60, you could sell to open an equal amount of Mar $64 Calls for $0.20 in order to bring the net debit of the position down to $0.40. Bull Call Spread = $0.60 - $0.20 = $0.40 debit spread

You must know the difference between debit spreads and credit spreads before you can consider trading options spreads due to the fact that each type carries with it unique characteristics that significantly affect your options account and risk appetite.

Purposes of Debit Spreads

So why do options traders and even market makers trade debit spreads? What is the purpose of debit spreads in options trading? Debit spreads are created primarily for offsetting the cost of owning long options positions. Out of the money call options are written in order to reduce the cost of owning lower strike price call options and out of the money put options are written in order to reduce the cost of owning higher strike price put options as shown in the preceding example. This is particularly useful when one expects the price of the underlying asset to move only moderately up to a certain ceiling (Learn about the Six Main Outlooks in Options Trading).

Debit spreads typically comes with limited profit potential and limited risk potential; this means that there is usually a ceiling on the maximum achievable profit and a floor to the maximum possible loss (usually the net debit paid), making the reward risk ratio of the options position predeterminable. As such, if you expect the price of the underlying asset to move significantly for an extended period of time (such as in a Sustained Bull Trend outlook), you would not use a debit spread as you won't want to limit the maximum profit potential of your options position.

Debit Spread Profit Ceiling Example Assuming you bought the QQQ Mar 61/62 Bull Call Spread in the preceding example. The position will continue to profit as QQQ rises but once the QQQ rises past the short strike price of $62, the $62 strike price call options would appreciate along with the $61 strike price call options, making it impossible for the position to make anymore gains beyond $62. Bull Call Spread maximum profit = $62 - $61 - $0.40 = $1 - $0.40 = $0.60 Since maximum risk is the net debit of $0.40, the reward risk ratio in this case would be: Reward Risk Ratio = $0.60 / $0.40 = 1.5

Types of Debit Spreads

There are debit spreads for every class of options strategies; Bullish, Bearish, Neutral as well as Volatile. Debit spreads are usually the limited profit and limited risk strategies of each class and you can find plenty of them listed below:

Bullish Limited Risk Limited Profit

Bearish Limited Risk Limited Profit

Neutral Limited Risk Limited Profit

Volatile Limited Risk Limited Profit

The most common bullish debit spread is the Bull Call Spread, the most common bearish debit spread is the Bear Put Spread, the most common neutral debit spread is the Butterfly Spread and the most common volatile debit spread is the Reverse Iron Butterfly Spread.

How Do Debit Spreads Work?

So, how do debit spreads work the way they do in options trading? What is the underlying principle behind debit spreads that allows them to be traded without margin with limited risk and profit potential?

All debit spreads consist of being long on an in the money option while simultaneously being short on an out of the money option. The extrinsic value of the out of the money option offsets the full cost of the in the money option (consisting of both intrinsic value and extrinsic value), providing the cost offsetting effect.

How Debit Spread Work Example 1 Assuming QQQ is trading at $61, its Mar $61 call options are trading at $0.60 and its Mar $62 Calls are trading at $0.20. You buy one contract of the Mar $61 Call options for $0.60 and offset that price by writing the Mar $62 Calls at $0.20. Net Debit = $0.60 - $0.20 = $0.40 In this example, the price of the position took a 33% discount going from $0.60 to $0.40 for a bull call spread position that will profit if the QQQ rally up to or beyond $62.

In a debit spread, maximum loss potential is limited due to the fact that if the price of the underlying stock goes opposite to what is expected, all options involved in the debit spread expire worthless together without further obligations with the maximum loss being the net debit paid. This is also why no margin is needed for the execution of debit spreads.

How Debit Spread Work Example 2 Following up on the above example... Assuming instead of rallying, QQQ drops to $59 by March expiration. The Mar $61 and Mar $62 calls both expires worthless. This means you lose the $0.60 paid towards buying the Mar $61 Call and gain in full the premium received from writing the Mar $62 Call, resulting in a loss of $0.60 - $0.20 = $0.40, which is the net debit paid towards putting on the bull call spread.

In a debit spread, maximum profit potential is limited due to the fact that if the price of the underlying asset move beyond the strike price of the short options, both the long and short option would appreciate at the same rate, resulting in no further profit possible. As such, the room for profit growth in a debit spread is usually the price range bracketed by the long and short strike price. As such, the maximum possible profit of a debit spread can be predetermined through mathematical formula and considered for options trade planning before actually executing the trade.

How Debit Spread Work Example 3 Following up on the above example... Assuming QQQ rallies to $63 by expiration. Your March $61 Call appreciates to $2 from $0.60 due to it becoming $2 in the money. Your March $62 Call appreciates to $1 from $0.20 due to it going $1 in the money. A net value of $2 - $1 = $1 results, returning a profit of $1 - $0.40 = $0.60, which is a 150% profit on original investment of $0.40. No matter how high QQQ rallies to by expiration, the maximum profit of the position is limited to $0.60 due to the short Mar $62 Calls appreciating at the same rate as the $61 calls beyond the $62 strike price. Lets assume QQQ rallies to $70 and see the effect on this debit spread position. Your March $61 Call appreciates to $9 from $0.60 due to it becoming $9 in the money. Your March $62 Call appreciates to $8 from $0.20 due to it going $8 in the money. A net balue of $9 - $8 = $1 results, returning the same profit of $1 - $0.40 = $0.60.

Bullish or Bearish debit spreads also result in better return on investments than outright call options or put options trading due to the lower cost of the position than outright call options or put options when the price of the underlying asset closes right at the strike price of the short leg by expiration.

How Debit Spread Work Example 4 Following up on the above example... Assuming QQQ rallies to $62 by expiration. Let's compare the return on investment between Peter who bought 1 contract of the Mar $61 Call outright and the return on investment of John who did the Mar 61/62 Bull Call Debit Spread. Peter's Mar $61 Call appreciates to $1 from $0.60 and makes a profit of $1 - $0.60 = $0.40 for a return of 67% on original investment of $0.60. John's Bull Call Spread from the above example made a profit of $1 - $0.40 = $0.60 for a return of 150% on original investment of $0.40.

Account Level Required for Debit Spreads

Unlike credit spreads, because debit spreads has a limited risk potential, it does not require margin to put on and is therefore possible for options traders with low account trading level. As such, debit spreads typically require options account trading level 3. Read more about Options Account Trading Levels.

Advantages of Debit Spreads

:: No margin needed
:: Predeterminable maximum loss and profit
:: Limited loss potential
:: Lower account level required
:: Better return on investment than outright positions in moderate trends

Disadvantages of Debit Spreads

:: Need to pay cash to trade
:: Limited profit potential
:: Can result in lost profit potential in sustained trends