What is debit spreads?
Let’s first begin with how options are traded. Just like trading stocks, it is all about minimizing risk and maximizing profits. To forge the ultimate strategy, a trader always indulges in buying and selling options at multiple strike prices. This is what spreads are, the range of the strike prices. However, unlike credit spreads, where you get money to open a trade, in debit spreads you actually pay to open a trade. This may leave you scratching your head but it will be clear in subsequent paragraphs.
This strategy can be applied in both upward and downward trends and accordingly it is divided into two parts:
• Bull call spreads: This is a bullish strategy. In this strategy, you buy a call option at a strike price and sell another at a higher strike in the same underlying at the same time.
• Bear put spreads: This is a bearish strategy. In this strategy, you buy a put option at a strike price and sell another at a lower strike in the same underlying at the same time.
Trading with marketXLS
Below is a template provided by marketXLS to trade options. With this template, you can not only import option chains but also track your trades in real-time. This is an example of a bull call spread. In this example, a net debit spread of $49 is created as you can see in the net investment section. Here a spread of $5 is created between strikes of $220 and $225 but you can adjust them according to your own convenience. You can also adjust the expiry and the underlying and get the respective last, ask bid and spread values.
Max, min, breakeven
Let’s understand the different scenarios associated with the above example with the help of a graph. Here units mean contract (100 shares).
• Let’s say the stock price of Microsoft trades below $220. In this situation, both leg1 and leg2 will be deemed worthless and you pay $49 in the form of a premium. This is the maximum loss you will incur in this trade.
• Since you have a net debit of $49, you will have to earn at least $49 to breakeven which is possible only if the stock moves past $220 to $220.49.
• The maximum you can earn from this trade is $951. Here is the calculation:
($225-$220) * 100 minus premium ($49)
• After this point the profits will be constant as you will have to sell it at $225, irrespective of the current market price.
The bear put spread will also be similar with respect to positions, maximum profits, and losses. The only difference would be in the direction of trades. You would be making put trades in a bear put spread.
The bottom line
The risks and profits are both limited in this strategy. However, if you see in the above example, the maximum profit is about 10%. To sum up, this strategy is for traders who are risk-averse and are skeptical about a stock’s movement in the near future.
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More about debit spreads here
More about credit spreads here
More options strategies here