Debit Spreads Explained

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Contents

Debit Spreads Option Strategy

The debit spread strategy is relative popular, easy and common for directional option trading. This defined risk vertical spread strategy is very similar to credit spreads. Differences are the risk profile and the more directional behavior of this spread. There are multiple different ways to set up debit spreads. I will be presenting the two most common ones.

Bull Call Debit Spread

Market Assumption:

When trading a Bull Call Debit Spread you obviously should have a bullish assumption. How bullish you should be depends on how far you go OTM. If you stay very close to the current price of the security, you can just be slightly bullish.

Setup:

  • Buy 1 Call
  • Sell 1 Call (higher strike)

This should result in a Debit (Pay to open)

Profit and Loss:

This can be a very profitable strategy. A Bull Call Debit Spread is a limited risk and limited profit strategy. The max profit is usually much higher than the max loss for debit spreads. Max profit is achieved when the price of the underlying is anywhere above the short strike. Max loss on the other hand occurs when the price is below the long strike. The break-even point is somewhere in between these strikes.

Maximum Profit: Strike of Short Call – Strike of Long Call (Width of Strikes) – Premium Paid – Commissions

Ex. 53 – 50 = 3 (3$ width of strikes) => 3$ *100 – 50$ (Premium Paid) – 5$ (Commission) = 245$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Premium Paid + Commissions

Ex. 50$ (Premium Paid) + 5$ (Commission) = 55$ (max loss)

Implied Volatility and Time Decay:

A Bull Call Debit Spread profits from a rise in implied volatility. This means it is best to use this strategy when IV is rather low (below IV rank 50).

Time Decay or the option Greek Theta works against this position and is therefore negative. Every day the long option loses some of its extrinsic value. The amount of value lost every day increases the closer you get to expiration.

Bear Put Debit Spread

Market Assumption:

As the name implies this is a bearish strategy and therefore your directional assumption should be bearish as well. The further you go OTM with this strategy the more bearish you should be.

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Setup:

  • Sell 1 Put
  • Buy 1 Put (higher strike)

This should result in a debit (Pay to open)

Profit and Loss:

A Bear Put Debit Spread is a risk defined and limited profit strategy. The max profit achievable is greater than the max loss. The maximum profit is achieved when the price of the underlying is below the short option strike. The max loss happens when the price is above the long strike. The break-even point is between these two strikes.

Maximum Profit: Strike of Long Put – Strike of Short Put – Premium Paid – Commissions

Ex. 50 – 48 = 2 (2$ width of strikes) => 2$ *100 – 40$ (Premium Paid) – 5$ (Commission) = 155$ (max profit)

(a normal option contract controls 100 shares, therefore *100)

Maximum Loss: Premium Paid + Commissions

Ex. 40$ (Premium Paid) + 5$ (Commission) = 45$ (max loss)

Implied Volatility and Time Decay:

Just as a Bull Call Debit Spread the Bear Put Debit Spread also profits from a rise in implied volatility and therefore should be used in times of low IV (IV rank under 50). Doing this will increase your chances of winning.

The Time Decay or Theta is negative and doesn’t work in the favor of this strategy. The long option will lose some extrinsic value as time passes. It loses value at a faster rate the closer you get to expiration.

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12 Replies to “Debit Spreads Option Strategy”

I am very interested in Options trading and started to study it. I am still very new at it, and still having trouble understanding its complexity mainly due to many terminologies and how Option is priced.

But Options is the safe way to invest (I am not much of a risk taker here comes to the stock market) that you can put the hedge around the risk. I am looking forward to learning more about Options.

If you are interested in learning more about options and how to earn consistent money with them you should definitely check out my education section here.

In the Bear Call and Bull Put Credit Spreads you identified the Break Even Point by a Formula such as: Short Strike – Net Credit or Short Price + Net Credit, Can please provide the formula for the Bull Call and the Bear Put Credit spread.

If possible can you elaborate in each of above strategies (Bull Call & Bear Put) where the profit exist above or below the BEP.

Thanks for your comment Camille.
Here is a list of formulas to calculate the breakeven points of different spreads:
Bear Call spread: Short strike + Credit received (max profit is achieved if the underlying’s price is below the short strike)
Bull Call spread: Long strike – Debit paid (max profit is achieved if the underlying’s price is above the short strike)
Bear Put spread: Long strike + Debit paid (max profit is achieved if the underlying’s price is below the short strike)
Bull Put spread: Short strike – Credit received (max profit is achieved if the underlying’s price is above the short strike)
I hope this helps. Otherwise, please let me know.

Hi Louis,
Do you have any articles on debit call/put adjustments? I am familiar with turning a long into a vertical spread, turning the vertical into a butterfly if the underlying keeps going down or . But, wondering if there is anything different. Thank you.

Sadly, I do currently not really have any articles on option strategy adjustments. But I have written your suggestion down and I will create training on adjustments sometime in the future.

A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price.

Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls.

My question: What I don’t understand is that:

– For a Single short call, if the stock price increases above the strike price, we make a loss. But in the above vertical spread, in fact we gain when the stock price move above the higher strike price of the two calls?

Hi Nicole,
Thanks for your question. A vertical spread consists of two options: a short option and a long option of the same type at a different strike price. For a bull call spread, you buy a call and sell a call at a higher strike price. This means that the long call option will be worth more than the short call option. Because of this, there is a certain price difference between the two options. If the underlying’s price moves above the strike price of the short option, you will be able to take advantage of this price difference because the long option will always be worth more than the short option. In other words, the long option is the dominant one and thus it has more influence on the payoff than the short option. Therefore, a bull call spread is a bullish strategy.
I really hope this helps.

Using this example, wouldn’t you still make money if the underlying goes past your short strike, because the long will gain in value faster than the short loses value if the underlying goes up in price? The long and short can’t be cancelling each other’s gain or loss exactly, correct? I ask because the payoff diagram shows the profit to stop at the short strike.

Hi Tim,
To calculate the break-even point of a bull call spread, you simply add the net cost of the spread to the lower (long) call strike. If the price of the underlying is anywhere above this price at expiration, the position will achieve a profit and vice versa. It is at this point that the long call’s gain and short call’s loss cancel each out exactly. Above it, the long call is worth more and below it the short call has a bigger loss.
I hope this answers the question. Otherwise, let me know.

Thanks for the super fast response. I think the only thing that I’m still confused with is the 1.) max profit calculation and 2.) the profit loss diagram.

1.) Max profit – your article states that Max profit = Strike of Short Call – Strike of Long Call (Width of Strikes) – Premium Paid – Commissions. This calculation makes sense if we are expecting to exercise both positions, or in other words calculating the instrinsic values. This calculation is not necessarily what the profit/loss would look like if we were just trading contracts due to option prices being different from stock prices, correct?

2.) Profit/Loss diagram makes sense if it is showing instrinsic value only.

Hi Tim,
The profit and loss diagram and the max profit/loss calculations are for the price of the position at expiration. So you are correct that they only show intrinsic value. At expiration, there is no extrinsic value left (because there is no time left till expiration). The blue line in the profit/loss diagram shows how the P&L looks sometime before the expiration date.
The formula to calculate P&L before expiration is much more complicated as you have to take many other market variables into account. If you are interested in such a formula, I recommend checking out my article on the black scholes formula.
If you have any other questions or comments left, please let me know.

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Debit Spreads

All About Debit Spreads – Definition, An Example, and How to Use

A debit spread comes about when you purchase one option and simultaneously sell an option (for the same underlying security, of course), and you have to shell out some cash to buy the spread. When you buy a debit spread, except in unusual circumstances (see below), you only have to come up with the difference between what the option cost that you bought and what you received from selling the other option to someone else.

Debit spreads are purchased to reduce risk. The other side of the coin is that the maximum gain is limited. For example, you might buy a one-month call option at the 70 strike for XYZ stock selling at $70 and pay $3.00. If you just bought the option, your cost would be $300 plus commissions, and that is the maximum you could lose. If the stock goes up to $80, you could sell the option for $10.00 and make a whopping gain of $700. However, it doesn’t happen that way very often. Stocks usually don’t shoot up by $10 in a single month.

Another choice would be to buy a debit spread, sharing both the risk and potential reward with someone else. You could probably sell a one-month 75 call on the above stock for $1.50. If you did that, you would collect $150 from someone else and cut your total risk in half. (Your debit spread in this case would be called a vertical spread.) If the stock goes up to $75 in one month (a much more likely event that having it go up to $80), you would make a gain of $350 less commissions on an investment of $150. At a $75 ending price, the person who bought the 75 call would lose his entire investment while you made over 200% on yours.

If the stock did manage to go up to $80, your debit spread would still earn you $350, but that is the maximum you could ever gain. Meanwhile, at $80, the person who bought the 75 call would also make $350 on his investment. In the real world, however, your chances of a maximum gain are many times greater than the person who did not buy a debit spread, but only bought a call option instead (and paying the same amount, $150, for his investment as you did for your debit (vertical) spread).

Debit spreads do not have to be only vertical spreads. A calendar spread, also called a time spread or a horizontal spread, is also a debit spread. Diagonal spreads can also be debit spreads. For example, you could buy a call option with many months of remaining life and sell a higher-strike call with only a single month of remaining life. That would be a debit (diagonal) spread. As with most debit spreads, you would only have to come up with the difference between what you paid for the long option and what you received by selling the short option.

There are certain spreads where you have to come up with more cash than the debit spread cost. For example, if you bought a diagonal call spread, buying a 70 strike call with 6 months of remaining life and selling a 65 call with only a single month of remaining life, you might be able to buy the spread at a debit. However, theoretically, you could lose $500 on the spread (if the stock shot higher, above $70, and never returned.

The broker would charge you a $500 maintenance requirement on this spread even though it is highly unlikely that you would ever lose that much. At the end of the first month when the 65 strike call expired, you would have to buy it back for its intrinsic value. Of course, it is unlikely that you would lose much if the stock did shoot up above $70. When you bought back the expiring 65 call, your 70 call with several months of remaining life could probably be sold for a greater amount than it cost you to buy back the 65 call.

In my discussion of spreads, I am assuming that you will never allow an in-the-money call or put to be exercised (i.e., either buying someone’s stock at the call price or forcing someone to buy shares of your stock at the put price). The great majority of the time, option traders choose to close out in-the-money options at or near expiration rather than buying or selling shares of stock. Shares of stock are for stock investors. Option investors are different – they prefer to tie up less money (while also trying to make a much higher return on investment than owning stock). Owning stock usually involves waiting patiently for years for it to go up. Option traders are not so patient. They like to see action today and tomorrow, not a decade from now.

For a good explanation of debit spreads in action, get a free report entitled “How to Make 70% a Year With Calendar Spreads” when you sign up for our free newsletter.

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Vertical Spreads Explained: The Ultimate Guide

Vertical spreads are the most basic options strategies that serve as the building blocks for more complex strategies.

Traders can use vertical spread options strategies to profit from stock price increases, decreases, or even sideways movements in the share price.

In this comprehensive guide, we’ll cover everything you need to know about trading verticals.

What is a Vertical Spread?

A vertical spread is an options strategy constructed by simultaneously buying an option and selling an option of the same type and expiration date, but different strike prices. A call vertical spread consists of buying and selling call options at different strike prices in the same expiration, while a put vertical spread consists of buying and selling put options at different strike prices in the same expiration. Vertical spreads can be bullish or bearish.

Consider the following example:

June 2020 Call Options

Strike Price

Buy/Sell

Quantity

Buy

Sell

In the above example, a trader is buying one contract of the 150 call while also selling one contract of the 175 call. Both call options are in the June 2020 expiration cycle.

The trade is considered a call vertical spread because the trader is buying and selling call options that are in the same expiration cycle but have different strike prices.

Vertical Spread

A category of options strategies that are constructed with two options at different strike prices in the same expiration cycle. One option is purchased and the other option is sold.

In the next sections of this guide, we’ll cover the four types of vertical spreads:

The Bull Call Spread

The Bear Call Spread

The Bear Put Spread

The Bull Put Spread

We’ll show you how to set them up and when to trade them, as well as look at some expiration payoff diagrams and performance visualizations of real trade examples.

In the following examples, we’ll start by focusing on the directional aspect of each strategy. After covering each of the strategies, we’ll discuss more advanced topics such as how time decay and implied volatility play a role in the profitability of each strategy.

The Bull Call Spread Strategy

The bull call spread is, you guessed it, a bullish vertical spread constructed with call options. Bull call spreads are also commonly referred to as long call spreads, call debit spreads, or simply buying call spreads.

For a quick explanation of the strategy, check out Investopedia’s guide here.

In this guide, we’ll cover the strategy in great detail. Let’s start with the strategy’s basic characteristics:

How to Set Up the Trade

Buy a call option and simultaneously sell another call option at a higher strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bull call spreads make money when the share price increases, as the call spread’s value rises with the share price (all else being equal). Ideally, the stock price rises to the short call’s strike price by expiration.

When to Buy Call Spreads

Traders buy call spreads when they believe a stock’s price will increase, but not necessarily to a price higher than the strike price of the call that is sold.

Breakeven & Profit/Loss Potential

Breakeven Price = Long Call’s Strike Price + Premium Paid

Maximum Profit Potential = (Spread Width – Premium Paid) x $100*

Maximum Loss Potential = Premium Paid x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

To fully understand the strategy’s characteristics mentioned above, let’s walk through a real long call spread example using Facebook (FB) options from 2020.

Bull Call Spread Example

Here are the details of the bull call spread we’re going to analyze:

Stock Price at Entry: $142.28

Call Strikes & Prices: Buy the 135 Call for $9.30; Sell the 150 Call for $1.54; Both options expire in 46 days.

Spread Entry Price: $9.30 Paid – $1.54 Received = $7.76 Premium Paid

Breakeven Price: $135 Long Call Strike + $7.76 Premium Paid = $142.76

Maximum Profit Potential: ($15 Spread Width – $7.76 Premium Paid) x $100 = $724

Maximum Loss Potential: $7.76 Premium Paid x $100 = $776

Let’s hammer these points home by visualizing the position’s expiration payoff diagram:

Now, to make sure you understand these expiration profits/losses, let’s walk through each important price zone for this specific bull call spread position:

Maximum Profit Potential

Stock Price(s): At or above the short call’s strike price of $150.

Why?: At any price equal to or above $150, the 135 call will be worth $15 more than the 150 call at expiration. Therefore, the 135/150 call spread will be worth $15, translating to a $7.24 gain per spread ($724 profit per spread) since the initial purchase price was $7.76.

Breakeven

Stock Price(s): $142.76 at expiration.

Why?: At $142.76, the long 135 call will be worth $7.76 at expiration, while the short 150 call will expire worthless. As a result, the 135/150 call spread will be worth $7.76, which is the same as the initial purchase price.

Maximum Loss Potential

Stock Price(s): At or below the long call’s strike price of $135.

Why?: At any price below $135 at expiration, the 135 call and the 150 call will both expire worthless since they will be out-of-the-money. As a result, the net value of the 135/150 call spread will be $0.00, which translates to a $7.76 loss per spread ($776 in actual losses per spread) because the spreads were purchased for $7.76.

How Did the Trade Actually Perform?

The expiration payoff graph only tells us part of the story.

The spread’s value (and therefore the profits and losses on the trade) will fluctuate as the share price changes on a daily basis.

With that said, let’s take a look at what happened to this FB call spread as the share price changed between the entry date of the trade and the spread’s expiration date:

In the first few days of this trade, FB shares fell, resulting in small losses on the long 135/150 call spread.

Fortunately, the price of the stock surged higher, which resulted in an increase in the call spread’s value (and therefore profits for the buyer of the spread).

At expiration, the share price was at $148.06, which resulted in a net profit of $530 per call spread.

With FB shares at $148.06 at the time of expiration, the long 135 call expired to a value of $13.06 ($148.06 Stock Price – $135 Long Call Strike), while the short 150 call expired worthless. As a result, the net value of the long 135/150 call spread at expiration is $13.06.

Net P/L: ($13.06 Expiration Value – $7.76 Premium Paid) x $100 = +$530 per spread .

Bull Call Spread

A bullish call spread constructed by purchasing a call option and selling another call option at a higher strike price (same expiration cycle). The maximum profit occurs when the share price is equal to or above the short call’s strike price at expiration, while the maximum loss occurs when the stock price is below the long call’s strike price at expiration.

In short, traders who buy call spreads want the share price to rise, ideally to a price equal to or greater than the short call’s strike price by expiration.

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The Bear Call Spread Strategy

The bear call spread is a bearish vertical spread strategy constructed with two call options in the same expiration cycle. The strategy is also commonly referred to as a short call spread, call credit spread, or simply selling a call spread. Read Investopedia’s quick guide on the bear call spread strategy.

When you sell a call spread, you’re betting against an increase in the price of the stock.

Here are the strategy’s general characteristics:

How to Set Up the Trade

Sell a call option and simultaneously buy another call option at a higher strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bear call spreads make money when the share price decreases (since call prices fall when the share price decreases, all else equal), or as time passes with the share price below the breakeven price.

When to Sell Call Spreads

Traders sell call spreads when they believe a stock’s price will decrease or trade sideways through the expiration date of the spread.

Breakeven & Profit/Loss Potential

Breakeven Price = Short Call’s Strike Price + Premium Paid

Maximum Profit Potential = Premium Received x $100*

Maximum Loss Potential = (Spread Width – Premium Received) x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s take a look at some visuals so you can better understand the metrics from the table above!

Bear Call Spread Example

For our bear call spread example, we’ll turn to real option data in Apple (AAPL) from 2020.

Here are the specific details of the trade we’ll visualize:

Stock Price at Entry: $141.46

Call Strikes & Prices: Sell the 142 Call for $1.93; Buy the 145 Call for $0.87; Both options expire in 32 days.

Spread Entry Price: $1.93 Received – $0.87 Paid = $1.06 Received

Breakeven Price: $142 Short Call Strike + $1.06 Premium Received = $143.06

Maximum Profit Potential: $1.06 Premium Received x $100 = $106

Maximum Loss Potential: ($3 Spread Width – $1.06 Premium Received) x $100 = $194

Tables are cool, but nothing beats a nice expiration payoff graph to visually represent an option strategy’s profit and loss potential:

Maximum Profit Potential

Stock Price(s): At or below the short call’s strike price of $142.

Why?: At any price equal to or below $142, the 142 call and 145 call will both expire worthless. As a result, the net value of the 142/145 call spread will be $0.00, which translates to a $1.06 gain per spread ($106 in actual profits per spread) because the call spreads were initially sold for $1.06.

Breakeven

Stock Price(s): $143.06 at expiration.

Why?: At $143.06, the short 142 call will be worth $1.06, while the 145 call will expire worthless. As a result, the net value of the 142/145 call spread will be $1.06, which is the same price the spread was sold for initially.

Maximum Loss Potential

Stock Price(s): At or above the long call’s strike price of $145.

Why?: At any price equal to or above the long call’s strike price of $145 at expiration, the short 142 call will be worth $3.00 more than the long 145 call. As a result, the 142/145 call spread will be worth $3.00. With an initial sale price of $1.06, the loss per spread is $1.94 ($194 in actual losses per spread).

How Did the Trade Actually Perform?

Ok, now that we’ve discussed the potential outcomes for this AAPL call spread at expiration, let’s see what actually happened to the position over time:

At the time of entering the short 142/145 call spread, AAPL shares were trading just over $141.

Shortly after selling the call spread, AAPL shares surged higher to $145, which means the short call spread was almost entirely in-the-money (ITM).

As a result, the price of the call spread increased, which translated to losses for any traders who had sold that spread for $1.06.

Fortunately, AAPL headed lower and was trading for $142.06 per share at the time of the call spread’s expiration date. At $142.26, the short 142 call was worth $0.26 while the long 145 call expired worthless.

The end result? The short 142/145 call spread is worth $0.26 at expiration, translating to $80 in profits for any trader who initially sold the spread for $1.06:

Net P/L: ($1.06 Spread Sale Price – $0.26 Spread Expiration Price) x $100 Option Contract Multiplier = +$80 Profit Per Spread.

Bear Call Spread

A bearish call spread constructed by selling a call option while simultaneously buying another call option at a higher strike price (same expiration cycle).

The maximum profit potential is realized when the share price is below the short call’s strike price at expiration, while the maximum loss potential is realized when the share price is above the long call’s strike price at expiration.

In short, sellers of call spreads want the share price to fall or trade sideways as time passes, as both of these events will lead to a decrease in the price of the spread, and therefore profits for the call spread seller.

For more on this options strategy, be sure to check out our ultimate guide on the bear call spread strategy.

Congratulations! You’ve just learned the two call spread strategies! Both of these strategies will always have a place in your options trading arsenal.

In the next two sections, we’ll walk through both of the put spread strategies.

The Bear Put Spread Strategy

The bear put spread is a vertical spread options strategy used by traders who believe a stock’s price will fall (they’re bearish). The position consists of buying a put option while also selling another put option at a lower strike price in the same expiration.

When a trader buys a put spread, they’re betting the stock price will decrease.

Bear put spreads are also commonly referred to as long put spreads, put debit spreads, or simply buying a put spread. For a quick run-down of the strategy, check out Investopedia’s concise guide on the bear put spread.

In this guide, we’re going to cover every detail you need to know about the strategy. Let’s start by looking at the strategy’s general characteristics and then hop into some trade examples:

How to Set Up the Trade

Buy a put option and simultaneously sell another put option at a lower strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bear put spreads make money when the stock price falls (since the put spread’s value will increase), all else being equal.

When to Buy Put Spreads

Traders buy put spreads when they believe a stock’s price will fall, but not necessarily to a price lower than the short put’s strike price.

Breakeven & Profit/Loss Potential

Breakeven Price = Long Put’s Strike Price – Premium Paid

Maximum Profit Potential = (Spread Width – Premium Paid) x $100*

Maximum Loss Potential = Premium Paid x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s check out a long put vertical in AMZN from 2020.

Bear Put Spread Example

Here are the trade details of our particular bearish put spread:

Stock Price at Entry: $780.22

Put Strikes & Prices: Buy the 800 Put for $44.88; Sell the 750 Put for $22.63; Both options expire in 59 days.

Spread Entry Price: $44.88 Paid – $22.63 Received = $22.25 Paid

Breakeven Price: $800 Long Put Strike Price – $22.25 Premium Paid = $777.75

Maximum Profit Potential: ($50 Spread Width – $22.25 Premium Paid) x $100 = $2,775

Maximum Loss Potential: $22.25 Premium Paid x $100 = $2,225

In this example, AMZN shares are at $780.22 when a trader buys the 800 / 750 put spread expiring in November of 2020.

The spread will be maximally profitable if AMZN shares are below the short put’s strike price of $750 at expiration.

Conversely, the trader will lose the entire premium paid if AMZN shares are above the long put’s strike price of $800 at expiration:

Let’s dive into the specifics of why these expiration profits/losses are the way they are:

Maximum Profit Potential

Stock Price(s): At or below the short put’s strike price of $750.

Why?: At any price equal to or below $750, the 800 put will be worth $50 more than the 750 put at expiration, which means the 800/750 put spread will be worth $50. With an initial purchase price of $22.25, the gain per spread is $27.75 ($2,775 in actual profits per spread).

Breakeven

Stock Price(s): $777.75 at expiration.

Why?: At $777.75, the long 800 put will be worth $22.25, while the short 750 put will expire worthless. As a result, the net value of the 800/750 put spread will be $22.25, which is the same price the spread was purchased for initially.

Maximum Loss Potential

Stock Price(s): At or above the long put’s strike price of $800.

Why?: At any price above $800 at expiration, the 800 put and the 750 put will both expire worthless since they will be out-of-the-money. As a result, the net value of the 800/750 put spread will be $0.00, which translates to a $22.25 loss per spread (a loss of $2,225 per spread in actual losses) because the spreads were purchased for $22.25.

How Did the Trade Actually Perform?

Alright, we’ve gone through the potential outcomes at expiration, but what about when AMZN shares fluctuation over time?

Here’s how this put vertical spread performed over time:

Ouch! At first, AMZN shares rallied from around $780 all the way up to $850, which translated to losses for the long put spread trader as the spread lost value.

At one point, the 800 / 750 put spread’s price fell to $10, which represents a $1,225 loss per spread for the trader who purchased the spread for $22.25:

($10 Spread Value – $22.25 Purchase Price) x $100 Option Contract Multiplier = -$1,225 .

Fortunately, with AMZN shares trading for $760.16 at expiration, the long 800 put was worth $39.84 ($800 Put Strike Price – $760.16 Stock Price), while the short 750 put expired worthless.

As a result, the final value of the long 800 / 750 put spread is $39.84, which translates to a $17.59 profit per spread (in option terms):

$39.84 Spread Expiration Value – $22.25 Spread Purchase Price = $17.59 Spread Profit.

$17.59 Profit Per Spread x $100 Option Contract Multiplier = +$1,759 Total Profit.

Bear Put Spread

A bearish put spread constructed by buying a put option while simultaneously selling another put option at a lower strike price (same expiration cycle).

The maximum profit potential is realized when the stock price is below the short put’s strike price at expiration, while the maximum loss potential is realized when the stock price is above the long put’s strike price at expiration.

In short, buyers of put spreads want the stock price to fall to a price equal to or greater than the short put’s strike price, as the put spread’s price will approach its maximum potential value.

The Bull Put Spread Strategy

We’ve covered a ton of content already, but we’ve still got one more strategy to discuss before moving on.

The bull put spread strategy is a bullish vertical spread constructed by selling a put option while also buying another put option at a lower strike price in the same expiration.

You may also hear traders refer to the bull put spread strategy as a short put spread, put credit spread, or simply selling a put spread.

For a quick explanation of the strategy, be sure to take a look at Investopedia’s concise guide on the bull put spread.

In this guide, we’re going to cover the strategy in detail. Let’s take a look at the strategy’s general characteristics and then dive into a real trade example in Netflix (NFLX):

How to Set Up the Trade

Sell a put option and simultaneously buy another put option at a lower strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bull put spreads make money when the stock price increases (since the put spread’s value will fall, all else equal), or as time passes with the stock price above the strike price of the put that is sold.

When to Sell Put Spreads

Traders sell put spreads when they believe a stock’s price will rise or trade sideways through the expiration date of the put spread.

Breakeven & Profit/Loss Potential

Breakeven Price = Short Put’s Strike Price – Premium Received

Maximum Profit Potential = Premium Received x $100*

Maximum Loss Potential = (Strike Width – Premium Received) x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s visualize this table by looking at an expiration payoff diagram and trade performance visualization of a real short put spread in NFLX.

Bull Put Spread Example

In the following example, we’ll examine a short put spread in NFLX that experiences both profits and losses over the duration of the trade.

Here are the specific trade details:

Stock Price at Entry: $146.92

Put Strikes & Prices: Sell the 145 Put for $6.60; Buy the 135 Put for $3.07; Both options expire in 46 days.

Spread Entry Price: $6.60 Received – $3.07 Paid = $3.53 Received

Breakeven Price: $145 Short Put Strike Price – $3.53 Premium Received = $141.47

Maximum Profit Potential: $3.53 Premium Received x $100 = $353

Maximum Loss Potential: ($10 Spread Width – $3.53 Premium Received) x $100 = $647

As always, we’ll explain the profit and loss potential and directional bias with a visualization of the expiration payoff diagram:

Here’s an explanation of the key price levels on this expiration P/L graph:

Maximum Profit Potential

Stock Price(s): At or above the short put’s strike price of $145.

Why?: At any price equal to or above $145 at expiration, the 145 put and 135 put will both expire worthless. As a result, the net value of the 145/135 put spread will be $0.00, translating to a $3.53 gain per spread ($353 in actual profits per spread) since the spread was initially sold for $3.53.

Breakeven

Stock Price(s): $141.47 at expiration.

Why?: At $141.47, the short 145 put will be worth $3.53 at expiration, while the long 135 put will expire worthless. As a result, the net value of the 145/135 put spread will be $3.53, which is what was initially collected for the spread.

Maximum Loss Potential

Stock Price(s): At or below the long put’s strike price of $135.

Why?: At any price below $135 at expiration, the short 145 put will be worth $10 more than the long 135 put, which means the 145/135 put spread will be worth $10. With an initial sale price of $3.53, the loss per spread is $6.47 ($647 in actual losses per spread).

How Did the Trade Actually Perform?

You know how to determine the profitability of a short put spread at expiration, but how do these spreads perform when the stock price changes before expiration?

Let’s take a look at how this short NFLX put spread performed:

When the 145 / 135 short put spread was initially sold for $3.53, NFLX shares were trading for nearly $147.

Over the first couple weeks of the trade (between 46 to 28 days to expiration), NFLX shares sold off to about $140, and the short put spread value expanded to $5.00. As a result, the bull put spread trader had approximately $147 in losses per spread ($3.53 Put Spread Sale Price – $5.00 Current Spread Price) x $100 Option Contract Multiplier = -$147 .

Fortunately, NFLX shares surged from $140 all the way up to $160, and the stock price was trading at $157.02 at the time of the short put spread’s expiration date.

It’s clear to see that the increase in the stock price resulted in a swift decrease in the price of the 145 / 135 short put spread, as the put options became substantially out-of-the-money (OTM).

With NFLX shares at $157.02 at expiration, the short 145 put and long 135 put both expired worthless, which means the value of the 145 / 135 put spread was $0.00. With an initial sale price of $3.53, the profit on the trade is $353 per short put spread:

($3.53 Put Spread Sale Price – $0.00 Spread Expiration Value) x $100 Option Contract Multiplier = +$353 Total Profit Per Spread .

Bull Put Spread

A bullish vertical spread constructed with put options: one short put and one long put at a lower strike price in the same expiration.

The maximum profit potential occurs when the stock price is above the short put’s strike price at expiration, while the maximum loss potential occurs when the share price is below the long put’s strike price at expiration.

In short, traders who sell put spreads want the stock price to rise or trade sideways as time passes, as both will result in the spread losing value over time (generating profits for the put spread seller).

To continue learning about this strategy, check out our ultimate guide on the bull put spread.

Time Decay & Vertical Spread Performance

How does time decay play a role in the profitability of vertical spread strategies?

Well, let’s start with one law that applies to ALL call and put spreads:

To reach max profit, the extrinsic value of the options in the spread must reach $0.00.

Take a look at the following example:

Stock Price: $153.91

Spread: Long 150 / 152.5 Call Spread

Spread Price: $1.68

Maximum Spread Value: $2.50 (Width of Call Spread Strikes)

As we can see, the stock price is well above the short call’s strike price of $152.50, but the 150 / 152.5 call vertical spread is only worth $1.68.

If the stock price is still $153.91 at expiration, we know that the 150 / 152.5 call spread will be worth $2.50, so why is the spread only $1.68?

The answer is that both options have extrinsic value remaining:

Stock Price: $153.91

Option

Option Price

Intrinsic & Extrinsic*

*Intrinsic Value = Stock Price – Call Strike Price

*Extrinsic Value = Call Price – Intrinsic Value

If you look carefully, you’ll notice that the value of the spread is $2.50 when only including the intrinsic value of each option:

Long 150 Call: $3.91 of Intrinsic Value

Short 152.5 Call: $1.41 of Intrinsic Value

Long Call Spread Value (Intrinsic Only): $3.91 Long Call – $1.41 Short Call = $2.50

Pretty cool, right?

Now, how does time decay come into the equation?

Knowing this, here’s exactly what you want to happen when you trade each of the four vertical spreads:

Bull Call Spread: Stock price increases to a level equal to or greater than the short call’s strike price while each option’s extrinsic value decays away as time passes.

Bull Put Spread: Stock price increases/remains above the short put’s strike price as time passes (as the spread’s value will approach $0 as the extrinsic value of each put option melts away).

Bear Call Spread: Stock price decreases/remains below the short call’s strike price as time passes (as the spread’s value will approach $0 as the extrinsic value of each call option diminishes).

Bear Put Spread: Stock price falls to a level equal to or below the short put’s strike price while the extrinsic value of each put option decays as time passes.

Time Decay & Vertical Spreads

For a vertical spread to reach the maximum profit level, the extrinsic value of the options in the spread needs to reach $0, which happens with the passage of time and favorable movements in the stock price.

Implied Volatility & Vertical Spread Performance

As always, implied volatility (the prices of options) plays a huge role in every options trading strategy. So, how does implied volatility play a role in the profitability of the four strategies discussed in this guide?

Here’s how:

Implied volatility measures how much extrinsic value is being priced into a stock’s options:

More “Expensive” Options ➜ Higher Implied Volatility / More Extrinsic Value

Less “Expensive” Options ➜ Lower Implied Volatility / Less Extrinsic Value

In the last section, you learned that vertical spreads can only reach max profit if the extrinsic value in the spread reaches $0. With that said, you want implied volatility (option prices / extrinsic value) to decrease as the stock price is moving in favor of your spread.

Many sources will tell you that you want to buy vertical spreads when implied volatility is low, as you’ll benefit from an increase in implied volatility.

This is partially incorrect.

If implied volatility increases (with all else being equal), that’s an indication that traders have bid up the option prices and therefore they have more extrinsic value.

If implied volatility increases and the stock price is moving in your favor, you’ll have less profits than you would if implied volatility had decreased.

Consider the following example that estimates the P/L of a long 150/160 call spread in FB based on various implied volatility levels with FB rising to $160:

However, the one time you’ll benefit from an increase in implied volatility (more extrinsic value) when trading vertical spreads is when the stock price moves against you. For example, if you buy a call spread and the stock price falls, you’ll be better off if implied volatility increases while the stock is falling:

As we can see, the long call spread will have larger losses if FB implied volatility falls while the stock price is falling. However, if implied volatility remains the same or increases, the losses on the spread will be less severe.

Ok, we’ve covered some heavy content here, so let’s break down the key takeaways from this section as they apply to each vertical spread:

When buying call spreads or selling put spreads, you want the stock price to increase while implied volatility falls (as both will lead to less extrinsic value in the spreads). Fortunately, a implied volatility typically falls as the price of the shares rise.

When buying put spreads or selling call spreads, you want the stock price to decrease while implied volatility falls (as both will lead to less extrinsic value in the spreads). Unfortunately, implied volatility usually increases when the price of the shares fall. As a result, the profits from a stock price decrease may be offset by an increase in implied volatility.

Implied Volatility & Vertical Spreads

Implied volatility represents how much extrinsic value exists in a stock’s option prices.

Since vertical spreads require a decrease in extrinsic value to reach the maximum profit potential, you want implied volatility to decrease as the stock price is moving in favor of your spread.

However, if the stock price moves unfavorably, an increase in implied volatility (extrinsic value) will result in less severe losses.

The “Perfect Storm” for Vertical Spreads

Ok, so you know how time decay and implied volatility play a role in the performance of vertical spreads.

Let’s put all of the concepts together and describe the “perfect storm” for profitable spread trading (generally speaking):

Favorable Change in the Stock Price

Favorable Change in Implied Volatility

Bull Call Spread

Increase

Bull Put Spread

Bear Call Spread

Decrease

Bear Put Spread

In the above cases, the passage of time is a benefit, as extrinsic value decreases as expiration gets closer.

Choosing an Expiration Cycle

With so many different expiration cycles to choose from, which one should you trade?

Since vertical spreads can only achieve the maximum profit potential if the extrinsic value in the spread reaches $0, trading expiration cycles with less than 60 days to expiration is common.

Here’s how the expiration you trade will impact the performance of each vertical spread (assuming you’re comparing similar spreads in different expirations):

Favorable Stock Price Change: Short-term spread rises in value more than the same spread in a longer-term expiration cycle.

Unfavorable Stock Price Change: Short-term spread loses more value than the same spread in a longer-term expiration cycle.

In other words, when you’re correct about a stock’s price movements (e.g. you buy a call spread and the stock price increases), trading a shorter-term expiration cycle will result in quicker profits relative to the same spread in a longer-term expiration cycle.

On the other hand, when you’re wrong about a stock’s price movements (e.g. you sell a put spread and the share price falls), trading a shorter-term expiration cycle will result in larger losses relative to the same spread in a longer-term expiration cycle.

Let’s take a look at some real call spread trades in NFLX to demonstrate these concepts.

Expiration Comparison: NFLX Call Spreads

To demonstrate the differences between trading shorter-term and longer-term spreads, let’s look at some bull call spreads in NFLX from 2020.

Here are the trade details:

Entry Date: April 3rd, 2020

Stock Price at Entry: $146.92

Trade #1: Buy the May17 140/160 Call Spread for $8.74 (46 Days to Expiration)

​Trade #2: Buy the Jun17 140/160 Call Spread for $8.95 (74 Days to Expiration)

In this case, we’re comparing the same call spread (buy the 140 call, sell the 160 call) in two different expiration cycles.

Let’s see how each spread performs as NFLX fluctuates over the next 45 days:

As we can see, both spreads move with each other, as they are constructed with the same options.

However, when NFLX takes a dip to $140 in the first two weeks, we can see that the May17 call spread has lost more money than the longer-term, Jun17 call spread.

When NFLX shares traded up to $160, we can see that the 140/160 call spread in the May17 expiration cycle was up over $1,000 at the highest point. However, at that time, the 140/160 call spread in the Jun17 expiration cycle was up only $700.

Since the June call spread has more time until expiration relative to the May call spread, the June call spread has much more extrinsic value remaining. As a result, the June call spread requires more time to pass before the spread’s value can increase to a price similar to the shorter-term May call spread with very little extrinsic value.

The Time to Expiration “Sweet Spot”

So, should you choose a longer-term or shorter-term expiration cycle when trading vertical spreads?

Like many things in options trading, there isn’t one perfect answer. However, there is a “sweet spot” you can use to balance the amount of time you have for your directional bias to play out, as well as the decay of extrinsic value if you’re right about the stock’s direction.

What’s the sweet spot?

Anywhere between 30-60 days to expiration is quite common for most options strategies (including vertical spreads), as you get a great balance of time decay (which helps you if your directional outlook is correct), but also adequate time for your trade to recover if the stock moves against you initially.

Choosing an Expiration

When choosing an expiration cycle to trade, keep in mind that shorter-term expiration cycles will be more beneficial to trade if the stock price moves favorably during the time the trade is held. The reason is that shorter-term options have less extrinsic value, and therefore vertical spreads can achieve their maximum profit levels much quicker than longer-term spreads.

However, if the stock price moves unfavorably during the time the trade is held, trading a spread in a longer-term expiration cycle will be more beneficial, as longer-term options have more extrinsic value.

In general, trading options with 30-60 days to expiration is common.

Explanation of Debit Spreads

Debit spreads are one of the two main types of options spreads that are classified based on the capital outlay: the other one being credit spreads. Unlike credit spreads, where you receive cash into your account at the point of creating them, creating debit spreads carries an upfront cost.

They are generally regarded as somewhat safer and less complicated than credit spreads so they are often used by those that are relatively new to using spreads as part of their trading strategies. On this page, we provide detailed information on them with the following topics all being covered:

  • How Debit Spreads are Created
  • Example of a Debit Spread
  • Using Debit Spreads
  • Types of Debit Spreads
  • Summary of Advantages & Disadvantages

How Debit Spreads Are Created

You can create debit spreads by using a broker to place two orders on options contracts that are based on the same underlying security. In the first instance you would place a buy to be able to purchase contracts, thus taking a long position on those contracts. This would obviously incur a cost.

You would then offset some of that cost by also taking a short position and placing a sell to open order to write contracts on the same underlying security. On the assumption that the contracts you buy are more expensive than the ones that you sell, you would have to pay out more money for your long position than you would receive from taking your short position. As such, the effect on your trading account would be a debit: hence the term debit spread.

Example of a Debit Spread

A simple example is if you were to purchase calls that are either at the money or in the money (i.e. the strike price is either equal to the price of the underlying security or below it), and then write cheaper calls with a higher strike price.

If you were to purchase 100 in the money calls that were trading at $2, then your investment would be $200. If you were then to write 100 calls that were out of the money with a lower strike price and were trading at $100, then you would recoup $100 – thus creating a debit spread where your overall cost is $100.

You can also create debit spreads on puts by selling options with a lower strike price than the ones you purchase. A debit spread is only created when you buy and sell different options contracts on the same underlying security.

Using Debit Spreads

A debit spread essentially involves taking opposing long and short positions on options contracts. They are typically created by taking the long position and buying contracts that are in the money, or at the money, and then effectively reducing the cost of taking that position by writing out of the money contracts and selling them.

In theory it doesn’t matter precisely where the strike price is relative to the underlying security, providing that the options that you write are cheaper than those that you buy.

The purpose here is basically to reduce your overall investment on owning specific options contracts and therefore limiting any potential losses. If the contracts you have bought expire out of the money and are worthless then the contracts you have written will be worthless as well. Although you will have lost your original investment on the ones you bought, you will have recovered some of those losses on the ones you sold.

Your losses and your profits are both limited, regardless of which way the price of the underlying security moves. As mentioned above, if the options you own expire worthless then so do the ones you have written – so your loss will simply be the difference between the money you invested in buying and the money you recouped through selling.

Your losses cannot be any higher than that, which means there is no need to trade on margin when using debit spreads as part of your trading strategy. However, your profits are potentially limited too of course. If the underlying security does move in the right direction and you are able to exercise to make a profit, then the holder of the contracts you have written will also be able to exercise too which will offset some of those profits.

The ideal scenario is that the underlying security moves only moderately in price. Given the nature of the spread, it’s possible that the contracts you own will increase in value and enable you to make a profit while the contracts you have written never make it in the money and expire worthless: meaning you effectively profit on both aspects of the trade.

For example, let’s say you created a debit spread and bought calls with a strike price of $50 on stock that was trading at $52 and wrote calls with a strike price of $55. If the stock went up to $54 but no higher, you would be able to exercise the contracts that you own to buy the stock at $50 and sell it at $50. However, the strike price in the calls you have written remains above the underlying stock and would therefore expire worthless, meaning that the price you sold those for would essentially be profit too.

These spreads are not ideal to use if you are expecting significant moves in the underlying security. Given the example immediately above, if the price of the stock kept on going up over and above the strike price of $55 in the calls you had written then your profit would increase on the calls you owned, but you would also incur losses on the calls you wrote.

Effectively, the maximum profit potential is defined by the difference between the strike price in the options you own and the strike price in the options you wrote.

Types of Debit Spreads

There is a range of different debit spreads that you can use for trading options. Which ones you use will be largely defined by the current state of the market, what sort of price movements you are anticipating and, of course, what sort of trading strategies you are employing.

Our comprehensive section on Options Trading Strategies contains further information on specific debit spreads and how they are used for the relevant strategy. The following are some of the more common types.

Summary of Advantages & Disadvantages

Debit spreads offer four distinct advantages to options traders. One of the biggest advantages is that they really help with trade planning, as it’s possible to predetermine the maximum potential loss and the maximum potential profit. There is also the fact that the losses are effectively limited to your initial cost at the time of creating them.

The knock on effect of that fact is the third advantage – they don’t require trading on margin and can therefore be used by traders who don’t necessarily have the ability to trade on margin. Finally, they can offer a greater return on investments than other strategies when there are moderate price movements.

The main disadvantage is the fact that there is a limit to how much profit you can make. If you predict a moderate price movement in a specific security and use a debit spread to try and profit from that, you will miss out on the potential profit you could have made from an outright position if the security in fact moves significantly in the direction you predicted. Basically limiting your losses comes with the cost of limiting your profits too.

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