What is a Debit Spread
A debit spread, or a net debit spread, is an option strategy involving the simultaneous buying and selling of options with different prices requiring a net outflow of cash. The result is a net debit to the trading account. Here, the sum of all options sold is lower than the sum of all options purchased, therefore the trader must put up money to begin the trade.
The higher the debit spread, the greater the initial cash outflow the trader incurs on the transaction.
BREAKING DOWN Debit Spread
Spread strategies in options trading typically involve buying one option and selling another on the same underlying security with a different strike price or a different expiration. However, many types of spreads involve three or more options but the concept is the same. If the income collected from all options sold results in a lower money value than the cost of all options purchased, the result is a net debit to the account, hence the name debit spread.
The converse is true for credit spreads. Here, the value of all options sold is greater than the value of all options purchased so the result is a net credit to the account. In a sense, the market pays you to put on the trade.
For example, assume that a trader buys a call option for $2.65. At the same time, the trader sells another call option on the same underlying security with a higher strike price for $2.50. This is called a bull call spread. The debit is $0.15, which results in a net cost of $15 ($0.15 * 100) to begin the spread trade.
Although there is an initial outlay on the transaction, the trader believes that the underlying security will rise modestly in price, making the purchased option more valuable in the future. The best case scenario is that the option sold will expire worthless, giving the trader the maximum amount of profit possible while limiting risk.
The opposite trade, called a bear put spread, also buys the more expensive option (a put with a higher strike price) while selling the less expensive option (the put with a lower strike price). Again, there is a net debit to the account to begin the trade.
The breakeven point for all bullish debit spreads using only two options is the strike price of the out-of-the-money (OTM) option plus the debit amount. For bearish debit spreads, the breakeven point is also the strike price of the out-of-the-money (OTM) option minus the debit amount.
For a bullish call spread with the underlying security trading at $65, for example:
Buy the $60 call and sell the $70 call for a net debit of $6.00. The breakeven point is $66.00.
Maximum profit occurs at the higher strike price. In this case, that would be $70 - $60 - $6 = $4.00, or $400 per contract.
Maximum loss is limited to the net debit paid.