Stock Graduate Call Notes 11-13-14: Debit Spreads

Debit Spreads

Debit spreads are an advance option strategy which requires a level 3 approval from your broker. A basic debit spread is a combination trade of buying (buy to open) and selling (sell to open) an option at the same time of differing strike prices but same expiration. A debit spread can be done with calls or puts. A debit spread with calls is bullish and is referred to as a bull call spread. A debit spread with puts is bearish and is referred to as a bear put spread. The net effect of the buying and selling options is money spent. If you end up receiving money, it is a credit spread which is exact opposite of the debit spread.

There are pros and cons with any strategy. Some reasons for doing debit spreads are to reduce the cost or risk of entering into an option trade, to reduce the daily price fluctuations of option trades, and it requires less movement of the underlying stock.

Some of the cons would be that you have a cap on your potential gain, a big move in your favor won’t necessarily result in an immediate benefit, and typically you have to stay in a trade until option expiration to reach your cap.

With a debit spread, you want both options to be in the money at expiration time, which will mean options being exercised. This will give you your cap or maximum gain. The amount of money spent to enter the trade is your risk or the maximum loss. In order to calculate your maximum gain, take the difference in strike prices x 100 (100 shares to a contract or 10 if a mini contract) x the number of contracts; from this amount, subtract out your cost to enter the trade. The result is your maximum gain.

You can close out of the trade at any time but typically plan on staying in the trade until expiration as long as it looks like both options end up in the money at that time. At expiration, options will be exercised and substituted and you will end up with your maximum gain. If the options are in the money before expiration, you could have options exercised but most exercising won’t occur until expiration or close to it.