What are Debit Spreads

A Debit Spread is an option strategy that is used to profit from a large move in price of a stock. Debit spreads can be compared to buying a naked call or put option, but with lower risk. This is done by buying an In-the-Money option and selling an Out-of-the-Money option. The premium received from selling an option offsets the total cost of buying the In-the-Money option and the risk is capped to the difference between the cost of the long leg and the income received from the short leg.

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Example – XYZ stock is currently trading @ $100

Bull Call Vertical – used when speculating on a large bullish move

• Buy $100 call @ $4 (Buy ITM call)
• Sell $110 call @ $1 (Sell OTM call)
• Max Risk = $3 ($4-$1)
• Max Reward = $7 ($110-$100-$3)

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Bear Put Vertical – used when speculating on a large bearish move

• Buy $100 put @ $4 (Buy ITM put)
• Sell $90 put @ $1 (Sell OTM put)
• Max Risk = $3 ($4-$1)
• Max Reward = $7 ($100-$90-$3)

The above examples show that debit spreads allow the trader to gain exposure to a large price move while improving the risk/reward profile of the trade. Both trades have a maximum risk of $3 as the premium received from selling an OTM option is used to reduce the total cost of buying the ITM option.

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Debit Spread Strategy

Debit spreads should be used when a large move in price is expected. This strategy is used better for individual stocks instead of ETF’s and indices. This is because individual stocks are more likely to experience large moves (from earnings and other news) while ETF’s and indices are an averaged over a number of securities and are less volatile. Longer dated options work better for debit spreads as time decay is minimized. Expirations between 5-8 weeks is recommended. 

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Risk vs Reward

Near the Money Debit Spreads (buying and selling options closer to the current price) will have a higher probability of winning. However, they will also have a lower risk/reward ratio. While Far out of the Money Debit Spreads will have a lower probability of winning but a better risk to reward ratio. It is important for traders to figure out the risk/reward ratio they are comfortable with and alter their debit spread strategy accordingly.

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The Optimal Debit Spread

While finding the optimal debit spread is based on how much the investor is willing to risk per trade, back testing has shows there are a few tips that help optimize debit spreads:

1. Buy 50-60 delta option and sell 10-15 delta option. The reason for this is because time decay is minimized when buying an in-the-money option. Selling a 10-15 delta option is ideal as there will still be a decent premium received to reduce the cost of the trade while ensuring that the short leg of the trade does not cap gains too much. 
2. Using the parameters above, the premium received from the short leg will offset roughly 10%-20% of the premium paid for the long leg. As the strikes are more in-the-money, the         probability of profit will be high while the risk/reward ratio will be low.

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How to Effectively Trade Debit Spreads

Debit spreads provide some advantages to simply buying a call or a put. Debit spreads allow for a lower risk as the short leg offsets the premium paid for the long leg. By lowering the risk, the trade has a better breakeven point. Time decay is also reduced due to the short leg of the debit spreads. However, debit spreads should not be used all the time. They should only be used when a large move is expected (breakout or breakdown). This means that the optimal setup for debit spreads tends to happen much less frequently when compared to credit spreads. 

Risk management is still key when trading debit spreads. Once a large move is expected and a debit spread is used, knowing when to exit the is vey important. If the large move in price does not materialize, the investor should exit the trade and cut the losses. Like buying a call or a put, debit spreads are not meant to be held to expiration. The optimal time to exit the trade is when price reaches the target price set by the investor. The target price should be set between a 75%-100% gain of the debit spread while the rule of thumb for mitigating losses is to exit the trade at a 50% loss. For example, if the debit spread was bought for $1 and is currently trading at $0.50, the losses should be cut. If the debit spread is trading at $1.75, it would be an ideal time to exit the trade or take partial profits. 

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