Learn to Trade Options: Breaking Down Debit Spreads

Breaking down debit spreads with options guru, Bernie Schaeffer

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    Trading options can be a complicated process as a lot of options strategies are available and traders need to evaluate all of the possible routes ahead of executing a trade. As such, Schaeffer's are starting a new educational series titled Optimizing Your Options Strategies. The beauty of options trading is that there are options strategies for every market environment. In this series, we will cover all available options strategies for an educated trader to consider when identifying trading opportunities.

    In this article, we will be talking about one of the most popular options strategies known as Debit Spreads. Utilizing a debit spread options strategy involves the simultaneous buying and selling of options of the same underlying stock with different strike prices, requiring a net outflow of premium. This results in a net debit in the trading account and, thus, the strategy gets the name of a debit spread.

    The sum of all the options sold is lower than the sum of all the options purchased, therefore the trader must put money down to set up the trade. The higher the debit spread, the higher the initial cash outflow the trader incurs in using the strategy.

    Debit spread options strategies generally involve buying one option and selling another option of the same class (call or put) on the same underlying stock with a different strike price and generally the same expiration date. However, a debit spread can contain three or more options as well, but the overarching concept remains the same. If the income collected from all the options results in a lower monetary value than the cost of all options purchased, the result is a net debit to the account (premium is debited from the trader's account).

    The opposite of a debit spreads options strategy is a credit spread options strategy where, instead of debiting premium from a trader's account, the trader receives a net premium in his account upon executing the trade.

    The maximum profit realized from a debit spread trade is the difference in strike prices minus the net premium debited from the account, realized when the options are in-the-money (ITM). The maximum loss incurred is limited to the net premium paid upfront from the trader's account when both options expire worthless.

    Different Debit Spread Options Strategies for Different Trading Objectives

    There is a range of different debit spread strategies that one can use when trading options. The trader decides the optimum strategy to be used based on the current state of the stock, what sort of price movement the trader is anticipating, and what type of options trading strategies the trader is comfortable with. Debit spread options trading strategies can be based on a bullish posture, a bearish posture, or a neutral posture on future stock price action.

    Bullish options strategies are traded when the options trader expects the underlying stock price to increase from the current price. It is necessary to assess how high the stock price is anticipated to go in the specific time frame so that traders choose the optimal options trading strategy. Bullish debit option strategies should be generally used for moderate bullish postures. These strategies are used because the maximum profit is capped, but the margin requirement is less considering the nominal exposure.

    A bull call spread is a popular example of bullish debit spread options strategies. A bull call spread is when a trader buys a lower strike price call option and subsequently sells a higher strike price call option to pay a net premium debit.

    Bearish options strategies are used when the options trader expects the underlying stock price to decrease. It is necessary to assess how low the stock is anticipated to go during a specific time frame, because bearish debit spreads should only be used when the trader has a moderately bearish posture.

    A bear put spread is a common example of bearish debit spread option strategies. A bear put spread is used when a trader buys a higher strike price put option and subsequently sells a lower strike price put option to pay a net premium debit.

    Neutral options strategies are employed when a trader expects the underlying stock price to not move much from the current market price in the desired time period. it is necessary to assess all possible situations here becaus,e if you wrong, you may start to lose money fast.

    A butterfly spread is a popular example of a neutral debit spread options strategy. A long butterfly spread with calls is a three-part strategy that is created by buying one call at a lower strike price, selling two calls with a higher strike price, and buying one call with an even higher strike price. All calls have the same expiration date, and the strike prices are equidistant.

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