Debit Spreads Explained

In this article we will focus on an in-depth discussion of debit spreads.

Definition

A debit spread is an options spread for which the trader has to pay a net debit to enter into
the transaction. This involves buying ATM or ITM options and simultaneously selling cheaper
OTM options.

Purpose

The purpose of a debit spread is to at least partially offset the cost of a long options position
by selling the same number of options further out of the money.

A typical debit spread

The well-known bull call spread and bear put spreads are two of the simplest debit spreads
available to the trader. Below the risk/reward profiles of these two strategies are highlighted.

Fig. 9.26(b) – Bear Put Spread

Fig. 9.26(a) – Bull Call Spread

Characteristics of a debit spread

In both cases the reader will notice that:

a) The trade has limited upside potential.
b) It also has limited downside potential.
c) In our example the maximum potential profit is higher than the maximum potential
loss.

Maximum profit of debit spreads

The maximum profit in our example is reached at the strike price of the short options. After
this the short options start making a loss, the long options make a profit and the net effect
equals zero.

The profit at that point is equal to the difference between the strike price of the long and the
short options less the net debit paid to enter the position.

Maximum loss of debit spreads

The maximum loss of the debit spreads in our example is equal to the net debit paid when the
position was set up, i.e. the cost of the long options less the premium income from selling the
short options.

Benefits and disadvantages of a debit Spread

One of the biggest benefits of a debit spread is that it involves no margin. The lower cost also
means it can actually provide a better return on investment that a straight long call or long put.
Furthermore, the maximum profit and maximum loss of the position is known from the outset.

The latter could of course also be seen as a disadvantage; there is no longer the unlimited
profit potential of a long call or long put.

Directional vs non-directional

Both the examples above involve directional trades, i.e. the trader has to have a view of
whether the market will be going up or down. If he or she is wrong, the trade will result in a
loss. As we have seen, this loss will be limited to the net debit – but it will nevertheless be a
loss, which is not what one wants from any trade.

The other alternative is to simply combine a bull call with a bear put. This gives one a reverse
iron butterfly spread, illustrated below.

Fig. 9.26(d)

From the above chart it is immediately clear that the strategy still has a limited maximum profit
and a limited maximum loss, but it is no longer directional, i.e. it will make money if the price
of the underlying asset moves to the upside or to the downside.