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 of the same class 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.
How a Debit Spread Works
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.
Example of a Debit Spread
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 happens when the security expires at or above the strike of the option sold. This give 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 bullish (call) debit spreads using only two options of the same class and expiration is the lower strike (purchased) plus the net debit (total paid for the spread). For bearish (put) debit spreads, the breakeven point is calculated by taking the higher strike (purchased) and subtracting the net debit (total for the spread).
For a bullish call spread with the underlying security trading at $65, here's an example:
Buy the $60 call and sell the $70 call (same expiration) for a net debit of $6.00. The breakeven point is $66.00, which is the lower strike (60) + the net debit (6) = 66.
Maximum profit occurs with the underlying expiring at or above the higher strike price. Assuming the stock expired at $70, that would be $70 - $60 - $6 = $4.00, or $400 per contract.
Maximum loss is limited to the net debit paid.