Digging Into Debit Spreads
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The last few weeks, I’ve spent a lot of time covering option credit spreads. They’re one of my favorite ways to create a trading edge and generate income.
However, a lot of you have asked me to explain how option debit spreads work, and rightfully so.
Option debit spreads can help you lower the cost of buying a call or put option when you want to make a directional bet on a stock, if you’re willing to cap your gains.
Today’s newsletter explains how to construct debit spreads and the best times to use them.
And if you stick with me until the end, I’ll give you a few ideas to get you started.
Constructing a Debit Spread
Option debit spreads are the exact opposite of credit spreads.When you initiate an options debit spread, you pay a debit. This is the maximum amount you can lose on the trade.
Unlike option credit spreads, the clock works against you with out-of-the-money option debit spreads. In-the-money debit spreads work a little differently, and we’ll discuss those at a later date.
Debit spreads come in two flavors:
- Call debit spread
- You buy one call option.
- You sell an offsetting call option for the same expiration at a higher strike price.
- You want the stock to finish above both strike prices by expiration to achieve maximum profit.
- If the stock stays below both strike prices by expiration, you hit maximum loss.
- Put debit spread
- You buy one put option.
- You sell an offsetting put option for the same expiration at a lower strike price.
- You want the stock to finish below both strike prices by expiration to achieve maximum profit.
- If the stock stays above both strike prices by expiration, you hit maximum loss.
Let’s take stock ABC as an example.
I want to buy a call option on ABC that costs $50. My payout graph would look like this.
In this chart, the blue line represents the payout diagram at expiration for a $50 strike price call option that costs $1.
You can see that for any price $50 and under, I lose that $1. At $51, I break even. If the price goes beyond $51, I make money.
Assume I don’t want to pay that full $1. I can sell an option further out of the money to lower that cost.
Let’s sell the $51 strike for $0.75.
Here’s what selling that option by itself looks like.
If you follow the blue line in this payoff graph, you can see how I can achieve a maximum profit of $0.75 for any price below $51 at expiration. At $51.75 I break even. If the price goes beyond $51.75, I lose money.
Now, when I combine these two actions — buying the $50 strike call option and selling the $51 strike call option — I’m left with the following:
$1.00 debit I paid for the $50 strike call option – $0.75 credit I received for selling the $51 strike call option = $0.25 net debit.
This creates a payoff graph that looks as follows:
This chart combines the previous two charts, where the blue line represents the payoff at expiration. If the price drops below $50, I lose the $0.25 I paid up front to initiate the trade. That’s the maximum amount I can lose.
My maximum possible profit is the difference between the strike prices minus the debit I paid, or:
When to Use Debit Spreads
We all have come across situations where we see a great opportunity to buy calls or puts on a stock that trades above $1,000 a share. But who wants to risk $5,000 to buy one call contract on Google that expires in two weeks?Why not try a call debit spread instead?
Let’s take a look at a real example.
Here is a call option chain for Google (GOOGL) for the March 18 expiration.
The leftmost column gives us the most recently traded prices for each strike price. The strike prices are listed down the rightmost column. You can see at the top that the stock was trading exactly at $2,610.
If I wanted to buy the $2,620 call option for Google, it would cost me $72.40 per contract, or $72.40 x 100 shares = $7,240 per option trade.
That’s a lot of money.
To lower the cost of the trade, I can sell the $2,625 call option for $70.00, giving me a net out-of-pocket cost of $72.40 – $70.00 = $2.40 per contract, or $240 per option trade.
That’s a lot more manageable, though I’ve now capped my maximum profit to: $2,625 – $2,620 – $2.40 = $2.60 x 100 shares = $260.
This call debit spread allows me to participate in a bullish trade for Google using options without tying up as much capital.
Plus, from the outset, I know exactly how much I’m risking and potentially gaining.
Now, there’s one other important point I want to make about when to use debit spreads.
In the previous article about credit spreads, I stated that option credit spreads work best in periods of high implied volatility.
As you might expect, debit spreads work best in environments with low implied volatility.
Whereas traders want the options in a credit spread to expire worthless, they want a debit spread to expire with as much value as possible.
And since increases in implied volatility increase the price of an option, traders with out-of-the-money debit spreads benefit from increases in implied volatility.
Since implied volatility is mean reverting, meaning it moves toward its historical average over time, initiating debit spreads when implied volatility is at extreme lows increases the chance that implied volatility will increase and benefit your trade.
We’ve gone over a lot here today, so I want to know what other questions you have about debit spreads, what doesn’t make sense to you, or what you want me to expand upon.
Email me and let me know. While I can’t respond to everyone, I promise to read every email.