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.


The Best Tool to Learn Options Strategies

If you want to learn much more about hundreds of options strategies, I highly recommend checking out The Strategy Lab. The Strategy Lab is a tool designed to help traders understand options strategies, options pricing and the options market in general.

Learn more about The Strategy Lab.

8 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.

  2. Hi Louis

    In the Bear Call and Bull Put Credit Spreads you identified the Break Even Point by a Formula such as: Short Strike – Net Credit or Short Price + Net Credit, Can please provide the formula for the Bull Call and the Bear Put Credit spread.

    If possible can you elaborate in each of above strategies (Bull Call & Bear Put) where the profit exist above or below the BEP.

    Thank you

    1. Thanks for your comment Camille.
      Here is a list of formulas to calculate the breakeven points of different spreads:
      Bear Call spread: Short strike + Credit received (max profit is achieved if the underlying’s price is below the short strike)
      Bull Call spread: Long strike – Debit paid (max profit is achieved if the underlying’s price is above the short strike)
      Bear Put spread: Long strike + Debit paid (max profit is achieved if the underlying’s price is below the short strike)
      Bull Put spread: Short strike – Credit received (max profit is achieved if the underlying’s price is above the short strike)
      I hope this helps. Otherwise, please let me know.

  3. Hi Louis,
    Do you have any articles on debit call/put adjustments? I am familiar with turning a long into a vertical spread, turning the vertical into a butterfly if the underlying keeps going down or . But, wondering if there is anything different. Thank you.

    1. Sadly, I do currently not really have any articles on option strategy adjustments. But I have written your suggestion down and I will create training on adjustments sometime in the future.

  4. Hi Louis,

    A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price.

    Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls.

    My question: What I don’t understand is that:

    – For a Single short call, if the stock price increases above the strike price, we make a loss. But in the above vertical spread, in fact we gain when the stock price move above the higher strike price of the two calls?

    1. Hi Nicole,
      Thanks for your question. A vertical spread consists of two options: a short option and a long option of the same type at a different strike price. For a bull call spread, you buy a call and sell a call at a higher strike price. This means that the long call option will be worth more than the short call option. Because of this, there is a certain price difference between the two options. If the underlying’s price moves above the strike price of the short option, you will be able to take advantage of this price difference because the long option will always be worth more than the short option. In other words, the long option is the dominant one and thus it has more influence on the payoff than the short option. Therefore, a bull call spread is a bullish strategy.
      I really hope this helps.

Leave a Reply

Your email address will not be published. Required fields are marked *