Debit Spreads

A debit spread is initiated when an options player buys a call (or a put) and simultaneously sells a further out-of-the-money call (or put) to create a spread at an initial debit in the investor's account. This effectively limits both the dollar risk and the reward relative to a traditional option purchase. When the options are listed in the same monthly series, this is known as a vertical debit spread. Calendar debit spreads can also be implemented as a strategy, as discussed below.

The primary advantage of the debit spread strategy is that the investor is able to enjoy the benefits of time erosion in the option that he or she sells. That is, the time value that is included in the pricing of the written option will decrease as the option's expiration date draws near. A second advantage is that the move in the underlying equity does not have to happen as quickly with this spread strategy compared to the necessity for rapid movement for a straight call or put purchase. In exchange for this reduced risk, one's potential returns are capped. This differs from straight option purchases, when gains can, in theory, be unlimited.

In a bullish debit spread, the investor purchases an equity call at one strike and sells an out-of-the-money call at a higher strike. Both options in this vertical debit spread strategy have, by definition, have the same expiration date. In a bearish debit spread, the investor purchases a put while selling a further out-of-the-money put. The options are purchased and written simultaneously as a spread, with a net capital outlay. Therefore, it is known as a debit spread. In effect, the investor is partially financing the purchase of an option by selling a slightly cheaper, further out-of-the-money option on the same underlying stock. The investor anticipates that the spread will widen to as much as the difference between the strike prices of the options.

In a bull debit spread, your profit potential becomes greater when the underlying stock price is nearer the lower strike when the spread is established. Conversely, profit potential is reduced when the underlying stock price is closer to the higher strike. The opposite is true for a bear debit spread. In a bear debit spread, your profit potential becomes greater when the underlying stock is nearer the higher strike, and is reduced when the stock is closer to the lower strike. For both kinds of debit spreads, the profit and loss potentials are the same if the amount of the spread equals half the difference between the two strikes.

The maximum value of a debit spread trade will be the difference between the strike prices in the spread. In a bull spread, the strike price of the call option sold equals the highest point the underlying stock can reach to maximize the intrinsic value of the call option bought, and the spread reaches its maximum value when both options have little-to-no time premium (at or near expiration). In a bear spread, the strike price of the put option sold is the lowest that the equity may drop to maximize the profits on the purchased put option. If the move happens too quickly, the written option will still carry more time premium relative to the deeper in-the-money option that was purchased. Therefore, one's profit will not be fully maximized.

The maximum return for a debit spread on a percentage basis is the amount by which the respective strikes are apart less the debit, divided by the debit, multiplied by 100. For example, with XYZ stock trading at 62, you purchase an XYZ March 60 call for a premium of 3 and sell the March 65 call for a premium of 1. Your debit is therefore 2 (3-1). The maximum value of the position is 5 (65-60). In this example, your maximum return is [(5-2)/2]*100, or 150 percent.

In the above example, why is your maximum value five points? When you purchase a call, the contract gives you the right to purchase 100 shares of the underlying stock at that strike price ($60 in the example above) anytime before expiration of that option. When you sell a call, you give the right to the buyer of the option to purchase 100 shares of the underlying at that strike price (in this case, $65) at anytime before expiration of that option. Again using the example above, let's assume the stock closed at 68 on March expiration, moving substantially in your favor. At expiration, the intrinsic value of the March 60 call (which you purchased) would be 8, while the intrinsic value of the March 65 call (which you sold) would be 3. In order to close the spread, you sell the March 60 call (collecting 8 premium points) and buy back the March 65 call (paying 3 premium points). Your net premium received is 5 points (8-3).

The debit spread approach thus allows one to achieve a less volatile risk/return profile, while still maintaining a reasonably sized profit potential in up, down, or slowly trending market environments.

A debit spread becomes categorized as a calendar debit spread when the purchased option and the sold option are from two different monthly series. The purpose of a calendar spread is to profit from the accelerated loss in time value of the short-term option (which is the sold position), relative to the option that is purchased. The most basic type of calendar spread is when the two options are at the same strike, despite their different expiration dates. This strategy is often a neutral strategy, but it can also be bullish or bearish in nature, depending on the options employed. If the two options have different strike prices, as well as different expiration months, this is termed a diagonal spread.