Lesson 13: What are debit spreads?

Let’s consider two broad categories of multi-leg option strategy — we’ll look at debit spreads in this lesson and credit spreads in the next.

A debit spread is an option strategy where you buy and sell options of the same class — that is, the same underlying asset, expiration date and option type — with different strike prices. It gets its name from the fact that you’ll need to spend some money to execute this position. In other words, the trade initially results in a net debit to your trading account.

In contrast, the credit spread is also an option strategy where you buy and sell options of the same class with different strike prices. However, your choice of which option you buy and which you sell means that the trade initially produces a net credit to your trading account.

The terms debit or credit don’t refer to the ultimate result of the trade. You can end up with a profit or loss with either trade, depending on the success of your strategy. And either strategy can be used to express a bullish or a bearish opinion on a stock or ETF.

Let’s dive into debit spreads.

A call debit spread involves buying one call option and selling another with a higher strike price. Both options have the same expiration date and underlying stock or ETF. This strategy is also known as a bull call spread.

Typically, the amount you pay to buy the lower strike call is greater than the proceeds you receive for selling the higher strike call, which results in a net debit to open the position. This is called a spread because the value of the position is based on the difference or spread between the two strike prices. 

A call debit spread is a bullish strategy because, ideally, you want the price of the stock to rise to the higher strike price or remain just below it. You might use this strategy when you believe an upside move is coming but you think that move will likely be limited.

Contrast this strategy with simply buying a call option without selling the higher strike call. The call alone is potentially a more profitable strategy if the underlying stock has a big move. However, a call debit spread is less expensive because the sale of the higher strike call generates proceeds that decrease the cost of buying the lower strike call. The trade-off is that you’re limiting your potential profit and you won’t benefit from a stock move above the higher strike price.

A put debit spread involves buying one put option and selling another with a lower strike price. Both options have the same expiration date and underlying stock or ETF. This strategy is also known as a bear put spread.

Typically, the amount you pay to buy the higher strike put is greater than the proceeds you receive for selling the lower strike put and you’ll pay a net debit to open the position. As mentioned, it’s called a spread because the value of the position is based on the difference or spread between the two strike prices.

A put debit spread is a bearish strategy because, ideally, you want the price of the stock to fall to or remain just above the lower strike price. You might use this strategy when you believe a downside move is coming but you think that move will likely be limited.

Contrast this strategy with simply buying a put option without selling the lower strike put. The put alone is potentially a more profitable strategy if the stock experiences a big decline. However, a put debit spread is less expensive because the sale of the lower strike put generates proceeds that decrease the cost of buying the higher strike put. The trade-off is that you’re limiting your potential profit and you won’t benefit if the stock experiences a big decline below the lower strike price.

• You can execute a debit spread as a multi-leg trading strategy by specifying the net price you want to pay. The net price will equal the cost of the more expensive, long side of the trade less the proceeds received for the less expensive, short side. Both parts of the trade have to be filled at the same time, at the total price you specify or better. If those conditions aren’t met, the trade won’t execute. In essence, it’s a form of contingent order — both parts get filled or neither do.
• You may receive a partial fill on a debit spread, but only in the ratio that you’ve specified. For example, if you’re buying 10 calls and selling 10 calls, you may be partially filled on 1 long call and 1 short call. Your fill will always reflect the specified ratio — in this example, 1 short call for every 1 long call.

• With this trade style, you place your order for the long calls or puts and the short calls or puts as separate orders. This can be done consecutively, if you’re looking for an opportunity to secure a more advantageous price on one or the other side of the trade, or simultaneously.
• Executing the trade this way will require much higher available margin in your account and a higher level of option trading approval. Note that the risk for the short side of the trade will be substantial for a short put or unlimited for a short call until the long side of the trade is executed. The risk is reduced if the long side of the trade is executed first.
• This is also known as “legging in” to a strategy.

If your debit spread is profitable before expiry, meaning that you could close both legs of the position and receive more than your original purchase price, you may want to close it before expiration. This allows you to control the outcome of the trade, although you may not realize the maximum profit the trade could achieve.

There are a number of scenarios that may require you to take action as the position nears or reaches expiry. Carefully review the "What happens at expiration" section of this article for details.

As mentioned, you might consider closing your position before expiry to free up capital and avoid the risk and cost of going through exercise and assignment.

You have the choice to sell to close the spread as a multi-leg strategy, close each leg separately or hold the position through expiration.

Here’s an overview of what can happen at expiration under different scenarios.

• If the stock's price is above the long strike price for a put, or below the long strike price for a call. Both options should expire worthless, and you’d lose the entire amount you spent to open the position.
• If the stock's price is below the short strike price for a put, or above the short strike price for a call, both options will expire in-the-money. Your long put or call may be automatically exercised, and you’ll likely be assigned on your short put or call. You’ll need to make sure you have sufficient available margin to cover the exercise and you should contact us to make sure the exercise takes place if that is part of your strategy.
• If the stock closes between the long strike and short strike prices, your long position may be automatically exercised, and your short position will expire worthless. This may result in your account receiving a short stock position, in the case of a put debit spread, or a long stock position, in the case of a call debit spread. You’ll need to make sure you have sufficient available margin to cover the exercise and you should contact us to make sure the exercise takes place if that is part of your strategy.

In a call debit spread at expiration, the breakeven is equal to the lower strike price plus the net premium you paid to open the position. Your gains are capped once the stock price moves above the higher strike price.

In a put debit spread at expiration, the breakeven is equal to the higher strike price minus the net premium you paid to open the position. Your gains are capped once the stock price moves below the lower strike price.

Any time you have a short option in your position, there’s the possibility of early assignment. This exposes you to certain risks, such as being unexpectedly long or short the underlying stock.

An early assignment occurs when an option that was sold is exercised by the long option holder before its expiration date.

If you’re assigned on the short put option of your put debit spread, you can take one of the following actions by the end of the following trading day:

• Sell the shares at the current market price.
• Exercise your long put option, meaning that you’ll sell the shares at the long strike price.

If you’re assigned on the short call option of your call debit spread, you can take one of the following actions by the end of the following trading day:

• Buy the shares at the current market price.
• Exercise your long call option, meaning that you’ll buy the shares at the long strike price.

In addition to possible early assignment, corporate actions such as stock splits, reverse stock splits, mergers, or acquisitions, can impact the underlying stock and subsequently affect the options held. These actions may cause changes to the option's structure, price, or deliverable. Stay informed about any corporate actions that may impact your positions. You can do this by regularly checking both your account holdings and any news on the stock.

It’s your responsibility to verify that your holdings continue to reflect the objectives of your chosen trading strategies.

Next up is Lesson 14: What are credit spreads?