Stock Market Debit Spreads Investing Explained
An options strategy that carries an upfront cost, debit spread seeks to attain maximum profit for the trader. How is this achieved? By ensuring that premiums paid for the spread’s long legs exceed the premiums received from its short legs. I will be explaining how debit spreads for stock market investors are a perfect alternative for investing, without owning shares.
Too complicated for you to understand? No problem, I’ll break down debit spreads by using more straightforward language that anyone can understand. Let’s begin.
Breaking Down Debit Spreads for Stock Market Investors
In options trading, spread strategies usually work like this—one option is bought and another one is sold on the same underlying security using a different expiration or a different strike price. Although some spreads can involve three or more options, the concept remains the same. If the revenue from all sold options is lower than the cost at which the options were bought, then this will result in a net debit to the account, and this is where the name debit spread comes from.
Used mostly by people who are new to options strategies, debit spread involves purchasing an option with a higher premium and selling another option with a lower premium at the same time. Here, the premium paid for the spread’s long option is more than the premium received from the written option.
The result of a debit spread is the premium paid or debited from the account of the trader or investor on the opening of the position. The primary purpose of a debit spread is to balance the cost associated with the ownership of long options positions.
Here is an example to understand the debit spread. Suppose, a trader buys a put option with a strike price of $24 for $9 and sells another put option with a strike price of $12 for $4. This means that the trader paid $5, or $500 for the trade. In case of out of the money (OTM) trade, the trader’s maximum loss is reduced to $500, as opposed to $900 if he only purchased the put option.
Now, there are two types of debit spreads: bull call debit spread and bear put debit spread. Following is an explanation of each.
Understanding Bull Call Debit Spread for Stock Market Investors
An options strategy, the bull call debit spread is used when the trader is bullish on the underlying security and wants to set up a vertical spread on a net debit. Having a bullish assumption is a primary condition for trading a bull call debit spread. How far you go Out of the money (OTM) will determine your level of bullishness. For example, you can be slightly bullish if you stay incredibly close to the security’s current price.
The setup of the bull call debit spread is like this: Buy 1 call and sell another call with a higher strike at the same time. An options strategy with limited risk, a bull call debit spread can be an extremely profitable strategy. The maximum profit usually exceeds the maximum loss for debit spreads. When the underlying security’s price is anywhere above the short strike, the maximum profit is achieved. On the other hand, maximum loss occurs when the price goes lower than the long strike. The point where break-even is achieved is somewhere between these strikes. Following are the formulas for calculating maximum profit and maximum loss with this trading strategy.
Maximum Profit = Short call’s strike-Long call’s strike (width of strikes) – premium paid-commissions
Suppose, the strike price of the short call is $53 while the long call’s strike is $50. In such a case, the width of strikes will be $3. Now, there are about 100 shares controlled by a normal option contract. So, we will multiply the $3 width of strikes by 100 which will give us a figure of $300. The premium paid is $50 while commissions amount to $5. Subtracting these amounts from the $300 figure gives us the maximum profit of $245.
Maximum Loss = Premium Paid + Commissions
Compared to the maximum profit, the calculation of maximum loss is fairly simple. Maximum loss can be obtained by simply adding the premium paid to the commissions. Keeping the premium paid and commissions at the same $50 and $5 will give us a maximum loss of $55.
Understanding Bear Put Debit Spread for Stock Market Investors
Another options strategy, the bear put debit spread is employed when the trader is bearish on the underlying security. Implemented the bear put spread option strategy can help set up a vertical spread on a net debit. Having a bearish assumption is a primary condition for trading a bear put debit spread. The further you go OTM with this strategy, the greater your level of bearishness should be.
The setup of the bear put debit spread for stock market investors is like this: sell 1 put and buy another put with a higher strike at the same time. An options strategy with a defined risk, a bear put debit spread is a good option if you’re fine having a limited profit. When the underlying security’s price is below the short strike, a maximum profit is achieved. On the other hand, maximum loss occurs when the price exceeds the long strike. The point where break-even is achieved lies between these strikes. Following are the formulas for calculating maximum profit and maximum loss with this trading strategy.
Maximum Profit = Long Put’s strike-short put’s strike – premium paid – commissions
With a long put’s strike of $50, short put’s strike of $2, premium paid of $40 and commissions worth $5, the maximum profit with the bear put debit spread options strategy will be $155.
Maximum Loss = Premium Paid + Commissions
Keeping the premium paid and commissions at the same $40 and $5 will give us a maximum loss of $45.
Debit spreads can be a bit complicated to understand, especially if you’re new to options trading. However, the above information on the topic should be a good starting point for you to use the debit spread strategy successfully. You can also visit the Basic Stock Options Definitions area to better understand more.