A debit spread is initiated when an options player buys a call (or put) and simultaneously sells a higher strike call (or lower strike 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. On the other hand, calendar debit spreads can also be implemented as a strategy; these will be discussed a little later.
The primary advantage of the debit-spread strategy is that the investor is able to enjoy the benefits of time decay in the sold option, which might help offset some of the time decay that he is battling with the purchased option. In other words, the time value that is included in the pricing of the written (sold) option will decrease as the option's expiration date draws near.
Bullish vertical debit spread
There are 2 types of vertical debit spreads: bullish and bearish. In a bullish debit spread, the investor might purchase an equity call at an in-the-money strike and sell an out-of-the-money call at a higher strike. Both options in this vertical debit spread strategy have the same expiration date. The options are purchased and written simultaneously as a spread, with a net capital outlay. This is a moderately bullish option-trading strategy in which you expect the stock to move modestly higher over a specific time period.
In effect, the purchased call has been partially financed by selling a slightly cheaper, further out-of-the-money option on the same underlying stock.
In a bull debit spread, your profit potential increases when the underlying stock price is nearer to the lower strike when the spread is established. Conversely, profit potential is reduced when the underlying stock price is closer to the higher strike when the spread is established. Meanwhile, 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 bullish vertical debit 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; the spread reaches its maximum value when both options have little-to-no time premium (at or near expiration).
However, 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.
On the other hand, the maximum loss on the bullish vertical debit spread is the premium paid for the position.
Example 1:
XYZ Corp. is currently trading at $81.25 and you expect the shares to climb to around $85 during the next month. While you’re bullish on the security, you don’t want to enter the position without slightly hedging your position. So, you purchase 1 (in-the-money) August 80 call for $4.00 and you sell 1 (out-of-the-money) August 85 call for $1.70. The net debit on the position is $2.30. By selling the out-of-the-money call, the cost of the long call has been partially offset.
Maximum profit: The maximum gain on this position is calculated by taking the difference between the two strikes and subtracting the debit paid for the position. In this example, the maximum gain would be 85-80 = 5-2.30 for a maximum gain of $2.70.
The gain on a bullish vertical debit spread is capped by the sold strike. Any gains above the sold strike will mostly likely cause the option to be exercised. The exercised option can then be covered by the long call option, which has the lower strike.
Maximum loss: The maximum loss on a bullish vertical debit spread is the price paid for the position and this will be incurred only if the stock drops to or below the long call strike at expiration. In this example, the debit of the $2.30 is the maximum loss.
Break-even Price: The break-even price can be found by adding the debit to the strike price of the long call position. In this example, the break-even level is 80 + 2.30 = 82.30. In other words, the shares of XYZ Corp. have to rally to at least $82.30 by expiration for the position to break even. Note how the breakeven in this transaction was lowered by the selling the call position. Had the trader only purchased the August 80 call for $4.00, his breakeven at expiration would have been $84.
Bearish vertical debit spread
In a bearish debit spread, the investor purchases a put while selling a lower strike put.
In a bearish vertical debit 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. Similar to the bullish vertical debit spread, both options in this bearish vertical debit spread strategy have the same expiration date. Both put options are initiated simultaneously as a spread, with a net capital outlay. This is a moderately bearish option-trading strategy in which you expect the stock to move modestly lower over a specific time period.
Furthermore, the maximum profit of a debit spread trade will once again be the difference between the strike prices in the spread less the net debit. In a bearish vertical debit spread, the strike price of the sold put option equals the lowest point the underlying stock can reach to maximize the intrinsic value of the put option bought, and the spread reaches its maximum value when both options have little-to-no time premium (at or near expiration). On the other hand, the maximum loss on the bearish vertical debit spread is the premium paid for the position.
Example 2:
ABC Inc. has been in a nasty slump and fallen to $26.62. You expect the shares to continue to limp lower during the next few weeks. So, you buy 1 in-the-money July 27.50 put for $1.50 and sell 1 out-of-the-money July 25 put for $0.50, resulting in a net debit of $1.00.
Maximum profit: The maximum gain on this position is calculated by taking the difference between the two strikes and subtracting the debit paid for the position. In this example, the maximum gain would be 27.50-25 = 2.50 – 1.00 for a maximum gain of $1.50.
The gain on a bearish vertical debit spread is capped by the sold strike. Any move below the sold strike will mostly likely cause the option to be exercised. The exercised option can then be covered by the long put option, which has the higher strike.
Maximum loss: The maximum loss on a bearish vertical debit spread is the price paid for the position and will be incurred only if the stock rises to or above the long put strike at expiration. In this example, the debit of the $1.00 is the maximum loss.
Break-even Price: The break-even price can be found by subtracting the debit from strike price of the long put position. In this example, the break-even level is 27.50 – 1.00 = 26.50. In other words, the shares of ABC Inc. have to fall to at least $26.50 by expiration for the position to break even.
A quick word about risk
The risk associated with the vertical debit spread strategy depends on the options the investor chooses to play. If you choose to sell an out-of-the-money option and purchase an at-the-money option, the initial cash outlay will be less, but the risk will be moderate to high. On the other hand, if you sell an out-of-the-money option but purchase an in-the-money option, the in-the-money position will be more expensive, but risk will become more moderate given the increased intrinsic value of the purchased option.
On the other hand, selling an out-of-the-money call against a deep in-the-money call is similar to a covered call position, as the deep in-the-money call will move nearly point-for-point with the underlying stock (due to the high delta), and the upside of the deep-in-the-money call is maximized at the strike price of the written call. The advantage of utilizing a vertical debit spread in this manner versus a covered call is that the capital outlay is less with a deep in-the-money option. The disadvantage to this strategy is that call purchasers would not receive the potential dividend payouts that a stock buyer is entitled to.
Horizontal Spread
Another kind of debit spread is the horizontal spread, or what is sometimes called the time spread or the calendar spread. This strategy is employed mostly by more sophisticated options traders who are looking for absolutely no movement in the underlying stock.
In this neutral options trading strategy, a spread is initiated by buying and selling options on the same underlying stock, with the same strike prices but with different expiration months. The goal behind the calendar spread is to sell time.
Unlike the vertical spread, the option speculator hopes that the price of the underlying security remains unchanged at expiration, allowing the near-month options to expire worthless. As the time decay of near-month options progresses at a faster rate than long-term options, the long-term options still retain much of their value.
Example: 3
Tech Inc. is currently trading for $45 and you believe the stock will continue to hover at that level during the near term. You might sell the Tech July 45 call for $4.50 and buy the August 45 call for $6.50. At time the horizontal spread is initiated, the July is 2 months from expiration and the August call is 3 months from expiration. The position had a net debit of $2 (6.50 – 4.50).
For the horizontal spread to work successfully, the July option must lose its time premium faster than the July option. If the stock price remains relatively stable as the July expiration approaches, the value of the spread should increase. With only one month remaining before the July expiration, time decay would have reduced the price of the July option to $1.50, while the August option would have a price of $4.50. As a result, the spread value would be $3. In this case, the position could be closed for a 1-point profit by selling the August calls and buying back the July calls.
The key to a long calendar spread is that the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.
Overall, debit spreads allow traders to take advantage of a move in the stock, while limited their risk. While a vertical debit spread is initiated with the expectation for a modest move in the underlying security, the horizontal debit spread is initiated with the expectation for no movement in the underlying security, allowing the investor to take advantage of time decay.
