Debit Vertical Option Spreads

by David Ondercin

You don't need a degree in accounting to understand and use Debit Spreads. Debit Spreads are really quite easy to understand. A Debit Spread is an Option strategy in which the Option you buy costs more than the Option you sell. Since the net affect of the spread is that the initial outlay of capital is greater than the amount taken in, it creates a debit in your account.

Let's look at an example of a simple Debit Spread:

Call Debit Spread

This spread is composed of buying the At the Money (ATM) $15 Call for $1.80 and Selling (Shorting) the $17.50 Call for $.85. The Net result is a Debit of $.95. Let's discuss the implications of this trade. Let's assume that the ATM Call expires in the same month as the Short Call. Spreads that have all Options expire in the same month are known as Vertical Spreads. Vertical Spreads are distinguished from Diagonal Spreads, which have different expiration months.

As with other aspects of trading, we need to understand the Risks associated with this trade, and the alternative actions you can take to protect yourself and still generate cash flow. The Prime Directive of Trading of any sort is to protect your account. Newbies must understand and apply the principle that all the "what ifs" are taken into account before you place the trade.

What is the worst thing that can happen to this stock trade?

The underlying stock can only do three things: it can go up, it can go down, and it can go sideways. If the stock makes a strong move upward, then the spread trader is faced with the possibility that the Short Call will expire In the Money and shares of stock will be "called away" from the trader.

This means that the trader must have enough money in his account to cover the cost of providing an equal number of shares of stock at the $17.50 Strike Price. If you traded five contracts, that's 500 shares times $17.50 or $8,750. The purchased Call would likely increase in value, say expiring for $2.80, and the Short Call premium $.85 would give to a total of $3.65 or $1,825. Your Net loss minus commissions would be $6,925.

To protect yourself from experiencing this painful loss, you could buy back the sold Call before expiration and sell the purchased Call for a profit. The results could range from a small loss to a small profit.

What happens if the stock plummets?

You face no prospects of being exercised on the Short Call, but the value of the purchased Call will diminish in value as it becomes an Out of the Money Call and time decay erases value quickly in the near month. The breakeven point is for the Long Call takes place when its value reaches $.95.

What happens if the stock goes sideways?

The best alternative, in this situation, is for the stock to rise to just under $17.50 so that the Short Call expires worthless and the Long Call expires $2.50 In the Money. This alternative provides a gross profit of $2.50 plus $.85 for a total of $3.35. You need to subtract the $1.80 you originally paid for the Call, leaving you a Net profit of $1.55. The Long Call must expire In the Money by at least $1.80 or it decreases your profit of the Short Call. All in all, Vertical Debit Spreads can be high risk trades. You might be better off buying a longer term Call Option, creating a Diagonal Spread, to give yourself more time to be right.

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