What Is A Debit Spread How To Trade It

You’re probably reading this because you want to know what is a debit spread how to trade it?

This options trading strategy combines buying and selling contracts with different strike prices, resulting in a cash outflow position or net debit position. This approach can work effectively in both upward and downward trending stock markets, allowing options traders to limit their risk.

But, the downside of the debit spread trading strategy is that with limited risk also comes a limited profit potential.

Learning what is a debit spread how to trade it is essential for options traders seeking to enhance their portfolio’s performance while maintaining strict risk control. Understanding the mechanics of debit spreads allows investors to take calculated positions with predefined risk levels.

In this guide, we’ll explore the fundamentals of debit spreads, examine their implementation, and show how traders can potentially generate returns using this versatile options trading strategy.

What is a Debit Spread How To Trade It?

In options trading, a debit spread is a trading strategy where a trader buys and sells two options contracts with different strike prices, but the option they buy has a higher premium than the one they sell.

The result is a net debit, which is where the options strategy gets its name.

By buying the option with the higher premium, the trader can protect themselves if the market goes against their position. At the same time, selling the option with the lower premium helps lower the overall cost of the trade, making it a more cost-effective and lower-risk options strategy.

How Does a Debit Spread Work?

To execute a debit spread strategy, you’ll need to work with an options broker to simultaneously place orders for contracts on your chosen underlying asset. Typically, you’ll start by selecting a strike price and placing a buy order to purchase your first options contract.

This costs money.

When implementing this options trading strategy, you’ll then reduce your initial investment by selling another options contract at a different strike price on that same underlying asset.

Since the options contract you’re buying has a higher premium compared to the one you’re selling, you’ll be paying more for your long position than you receive from your short position, resulting in a net debit to your account: this is why it’s called a debit spread.

Types of Debit Spreads

Below, we’ll explore the most popular debit spread strategies that options traders commonly use to beat the stock market. Here are the primary types:

Traders have access to several different types of debit spreads when implementing their options strategies. Each variation serves a specific purpose depending on your market outlook, risk tolerance, and whether you’re expecting the underlying asset to move up, down, or trade sideways. 

How to Trade a Debit Spread

Let’s look at a practical example: consider a trader who buys a call option for $3.75 and simultaneously sells another call option with a higher strike price for $3.25. This creates a bull call debit spread. The net debit is $0.50, resulting in a total cost of $50 ($0.50 x 100) to initiate the position.

Similarly, for a bearish outlook, traders can construct a bear put spread by buying a put option at a higher strike price while selling another put at a lower strike. As with the bull call spread, this strategy requires an upfront debit to establish the position.

Example of a Debit Spread Profit Calculation

Understanding the breakeven calculation is crucial when trading debit spreads – it’s calculated by adding the lower strike price to the net debit paid.

Here’s a practical scenario to consider:

Let’s say you implement a bull call spread when XYZ stock is trading at $45. Buy the $40 call and sell the $50 call for the same expiration date, paying a net debit of $4.00. Your breakeven point would be $44, calculated as the lower strike (40) plus the debit paid (4).

The maximum potential profit is realized if the stock closes at or above the higher strike price at expiration. With our $50 strike price, that’s $50 – $40 – $4 = $6.00, or $600 per contract.

Your risk is capped at your initial investment.

Benefits and Risks of Trading Debit Spread 

Advantages of Debit Spreads:

• The primary benefit of implementing a debit spread strategy is the built-in protection against significant losses.
• Trading debit spreads often requires less capital than purchasing single options positions outright.
• Debit spreads offer versatility in different market conditions.

Disadvantages of Debit Spreads

• Capped Returns: Despite the risk management benefits, debit spreads do come with limited profit potential.
• Transaction Costs: Setting up debit spreads involves multiple options contracts, which can result in higher commission costs and wider bid-ask spreads than simpler strategies.
• Time Sensitivity: The effectiveness of debit spreads heavily depends on market timing and price movement direction.

How much capital do I need to start trading debit spreads?

You need enough capital to cover the debit, which is the net premium paid for the spread. The minimum amount required is generally the debit cost per share multiplied by 100. For example, if the debit is $3 per share, you would need $300 to enter a single contract.

Example Calculation:

If you decide to trade a bull call debit spread on stock XYZ:

• Buy 1 XYZ call at $50 for $5.
• Sell 1 XYZ call at $55 for $2.
• The debit (total cost) = $5 – $2 = $3 per share.

For 1 contract (100 shares), the total capital required will be:

Tips for Success When Trading Debit Spreads

Now that you know what is a debit spread and how to trade it, I’ll leave you with 3 of my most important trading rules when trading debit spreads:

Rule #1: Buy In-The-Money and Sell At or Out-Of-The-Money

First, to increase the probability of success, buy an In-The-Money (ITM) option and sell an At-The-Money (ATM) or Out-Of-The-Money (OTM) option. This strategy gives you a higher chance of the spread expiring in-the-money, while keeping the overall cost lower.

Rule #2: Sell More Time Premium Than You Buy

Sell options with more time value than you buy. This helps reduce the cost of your debit spread and allows you to take advantage of time decay, which benefits you as the position moves closer to expiration.

Rule #3: Profit Taking in Pieces Increases Win Percentage

Take profits gradually as the trade moves in your favor. By scaling out of your position, you lock in gains and reduce the impact of potential market reversals, improving your chances of overall profitability.