Explanation of Debit Spreads

How Debit Spreads Are Created

You can create debit spreads by using a broker to place two orders on options contracts that are based on the same underlying security. In the first instance you would place a buy to be able to purchase contracts, thus taking a long position on those contracts. This would obviously incur a cost.

You would then offset some of that cost by also taking a short position and placing a sell to open order to write contracts on the same underlying security. On the assumption that the contracts you buy are more expensive than the ones that you sell, you would have to pay out more money for your long position than you would receive from taking your short position. As such, the effect on your trading account would be a debit: hence the term debit spread.

Example of a Debit Spread

A simple example is if you were to purchase calls that are either at the money or in the money (i.e. the strike price is either equal to the price of the underlying security or below it), and then write cheaper calls with a higher strike price.

If you were to purchase 100 in the money calls that were trading at $2, then your investment would be $200. If you were then to write 100 calls that were out of the money with a lower strike price and were trading at $100, then you would recoup $100 – thus creating a debit spread where your overall cost is $100.

You can also create debit spreads on puts by selling options with a lower strike price than the ones you purchase. A debit spread is only created when you buy and sell different options contracts on the same underlying security.

Using Debit Spreads

A debit spread essentially involves taking opposing long and short positions on options contracts. They are typically created by taking the long position and buying contracts that are in the money, or at the money, and then effectively reducing the cost of taking that position by writing out of the money contracts and selling them.

In theory it doesn’t matter precisely where the strike price is relative to the underlying security, providing that the options that you write are cheaper than those that you buy.

The purpose here is basically to reduce your overall investment on owning specific options contracts and therefore limiting any potential losses. If the contracts you have bought expire out of the money and are worthless then the contracts you have written will be worthless as well. Although you will have lost your original investment on the ones you bought, you will have recovered some of those losses on the ones you sold.

Your losses and your profits are both limited, regardless of which way the price of the underlying security moves. As mentioned above, if the options you own expire worthless then so do the ones you have written – so your loss will simply be the difference between the money you invested in buying and the money you recouped through selling.

Your losses cannot be any higher than that, which means there is no need to trade on margin when using debit spreads as part of your trading strategy. However, your profits are potentially limited too of course. If the underlying security does move in the right direction and you are able to exercise to make a profit, then the holder of the contracts you have written will also be able to exercise too which will offset some of those profits.

The ideal scenario is that the underlying security moves only moderately in price. Given the nature of the spread, it's possible that the contracts you own will increase in value and enable you to make a profit while the contracts you have written never make it in the money and expire worthless: meaning you effectively profit on both aspects of the trade.

For example, let’s say you created a debit spread and bought calls with a strike price of $50 on stock that was trading at $52 and wrote calls with a strike price of $55. If the stock went up to $54 but no higher, you would be able to exercise the contracts that you own to buy the stock at $50 and sell it at $50. However, the strike price in the calls you have written remains above the underlying stock and would therefore expire worthless, meaning that the price you sold those for would essentially be profit too.

These spreads are not ideal to use if you are expecting significant moves in the underlying security. Given the example immediately above, if the price of the stock kept on going up over and above the strike price of $55 in the calls you had written then your profit would increase on the calls you owned, but you would also incur losses on the calls you wrote.

Effectively, the maximum profit potential is defined by the difference between the strike price in the options you own and the strike price in the options you wrote.

Types of Debit Spreads

There is a range of different debit spreads that you can use for trading options. Which ones you use will be largely defined by the current state of the market, what sort of price movements you are anticipating and, of course, what sort of trading strategies you are employing.

Our comprehensive section on Options Trading Strategies contains further information on specific debit spreads and how they are used for the relevant strategy. The following are some of the more common types.

• Bull Call
• Bear Put
• Reverse Iron Butterfly
• Butterfly

Summary of Advantages & Disadvantages

Debit spreads offer four distinct advantages to options traders. One of the biggest advantages is that they really help with trade planning, as it's possible to predetermine the maximum potential loss and the maximum potential profit. There is also the fact that the losses are effectively limited to your initial cost at the time of creating them.

The knock on effect of that fact is the third advantage – they don't require trading on margin and can therefore be used by traders who don’t necessarily have the ability to trade on margin. Finally, they can offer a greater return on investments than other strategies when there are moderate price movements.

The main disadvantage is the fact that there is a limit to how much profit you can make. If you predict a moderate price movement in a specific security and use a debit spread to try and profit from that, you will miss out on the potential profit you could have made from an outright position if the security in fact moves significantly in the direction you predicted. Basically limiting your losses comes with the cost of limiting your profits too.