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

bull 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

bear 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.

2 Replies to “Debit Spreads Option Strategy”

  1. 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.

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