Debit Spreads
Long volatility exposure at a reduced cost.
Contents
What is a Debit Spread?
Vertical Debit Spread Variations
Call Debit Spread
Put Debit Spread
Strategy Construction
Call Debit Spread
Put Debit Spread
Call Debit Spread Payoff Function
Put Debit Spread Payoff Function
Call Debit Spread Example
Put Debit Spread Example
Synopsis
Debit spreads offer directional exposure with limited profits and losses, providing a higher probability of profit compared to outright options buying.
The strategy involves buying and selling options of the same class and expiry, resulting in a net debit and favorably shifting your breakeven price.
Call debit spreads (bull call spreads) are used when expecting a neutral to bullish move, while put debit spreads (bear put spreads) are used for neutral to bearish moves.
What is a Debit Spread?
A debit spread is a directional options strategy that limits potential profits and losses in return for a higher probability of profit. It moves up your break-even price, increasing your probability of profit — offering you directional exposure at a reduced cost basis relative to buying calls or puts outright.
The strategy is executed by buying higher premium options and selling lower premium options (of the same class) with the same expiry — resulting in a net debit. The short leg of the trade partially funds the long leg, favorably shifting your breakeven price.
Unlike credit spreads (which have negative vega), debit spreads have positive vega and benefit from increasing IV after being established.
Traders often put on debit spreads when IV is depressed and on the ascent.
Vertical Debit Spread Variations
Call Debit Spreads (aka bull call spreads -or- long call spreads)📈
Put Debit Spreads (aka bear put spreads -or- long put spreads)📉
Call debit spreads are neutral/bullish, while put debit spreads are neutral/bearish.
You might tee up a call debit spread when you think an asset is poised to make a move to the upside, whereas you might deploy a put debit spread when you think an asset is poised to make a move to the downside.
Strategy Construction 🏗
Call debit spread:
Buy a call at a lower strike price and sell a call at a higher strike price
Put debit spread:
Buy a put at a higher strike price and sell a put at a lower strike price
For call debit spreads, the premium paid for the long call exceeds the premium collected for the short call. For put debit spreads, the premium paid for the long put exceeds the premium collected for the short put. Both strategies are established for a net debit.
Your max profit is limited to the width of the spread (difference between strike prices) minus your initial debit. Your max loss is limited to the cost required to establish the strategy (i.e, your initial debit).
Call Debit Spread Payoff Function
Max profit:
Spot price is at or above the strike of the short (higher strike) call at expiry
Max loss:
Spot price is at or below the strike of the long (lower strike) call at expiry
Breakeven:
Long (lower strike) call strike price plus net premium paid
Call Debit Spread Example
SOL is trading at $38 and you're moderately bullish.
You buy 1000 $38 calls ($2.20 premium) and sell 1000 $42 calls ($0.90 premium).
1000 x $2.20 = $2,200 (debit)
-
1000 x $0.90 = $900 (credit)
=
1000 x $1.30 = $1,300 (net debit)
Max profit:
$2,700 ($4,000 - $1,300), realized if SOL is trading at or above $42 at expiry
Max loss:
$1,300 (initial net debit), realized if SOL is trading at or below $38 at expiry
Breakeven:
$39.30 ($38 + $1.30)
Put Debit Spread Payoff Function
Max profit:
Spot price is at or below the strike of the short (lower strike) put at expiry
Max loss:
Spot price is at or above the strike of the long (higher strike) put at expiry
Breakeven:
Long (higher strike) put strike price minus net premium paid
Put Debit Spread Example
SOL is trading at $38 and you're moderately bearish.
You buy 1000 $38 puts ($2.30 premium) and sell 1000 $34 puts ($1.10 premium).
1000 x $2.30 = $2,300 (debit)
-
1000 x $1.10 = $1,100 (credit)
=
1000 x $1.20 = $1,200 (net debit)
Max profit:
$2,800 ($4,000 - $1,200), realized if SOL is trading at or below $34 at expiry
Max loss:
$1,200 (initial net debit), realized if SOL is trading at or above $38 at expiry
Breakeven:
$36.80 ($38 - $1.20)
Conclusion
Debit spreads are a versatile and strategic tool in the world of options trading. They offer traders the ability to capitalize on directional moves while limiting both potential profits and losses. This risk management aspect makes debit spreads appealing to those seeking exposure to price movement without the unlimited risk of buying naked calls or puts. By carefully selecting strike prices and expirations, traders can tailor debit spreads to fit their market outlook and risk tolerance.
Furthermore, the positive vega characteristic of debit spreads allows traders to benefit from increasing implied volatility, making the strategy particularly attractive when IV is low and expected to rise. As with any trading strategy, understanding the mechanics, risks, and potential rewards of debit spreads is crucial for success.