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Last month we discussed the whats and wherefores of credit spread strategies, and today we’ll look at their more expensive cousins, debit spreads.
Whereas credit spreads are essentially a strategy to collect premium via the selling of options, debit spreads are closer to a straightforward call or put purchase, where our money is made (we hope) via a strong move in the underlying security in our direction.
How Are Debit Spreads Constructed?
A debit spread is, quite simply, a long call or put coupled with a short call or put with the same expiration date – the latter of which is sold to partially offset the cost of the former.
That partial offset results in a net debit for the trade – hence the name.
As with credit spreads, there are two types of debit spreads, one for when we’re bullish and one for when we’re bears.
A real life example best serves to illustrate the strategy.
1. A Bullish Call Spread
Let’s imagine we’re excited about the prospects for natural gas. We look at a chart of the United States Natural Gas Fund (NYSEArca: UNG), a reasonable proxy for the commodity, and this is what we see:
In our example, the chart shows that gas has broken above both a four-month descending trend line (in blue), as well as all other moving averages, and looks to possess good bullish promise.
You might consider buying an at-the-money January call, but the 20 strike looks a little dear at $4.55, so you can offset the cost with the sale of another call, further out of the money at 24. The 24 strike brings in $1.60, so your total debit for the spread is $2.95 ($4.55 – $1.60).
Profit/Loss Calculations
As far as profit/loss numbers go, the worst you can do with any simple debit spread is to lose your initial debit – in this case, $295.
The best you can do is the difference between the strikes (times 100), less your initial debit. In this example, that’s $400 less $295, or $105 per spread.
Trade Insights
Consider this as well: Had you just bought the 20 call, your upside would have been unlimited, but your break-even would have been $24.55 (long call strike + premium, or $20 + $4.55). With the spread, your upside is limited, but your break-even is lowered to $22.95 (long call + premium paid, or $20 + $2.95).
2. A Bearish Debit Put Spread
Fine and dandy so far, but what if we’re bearish on, say, the gold miners ETF?
Here’s what the chart shows:
Say the Market Vectors Gold Miners ETF (NYSEArca: GDX) just broke below support on significant volume, and you smell fear. You look to buy the December 17 strike put, but it’s going for $5.15 – a tad expensive for your taste. So you sell the December 13 strike at the same time, pull in $2.55 and end up with a debit of just $2.60 for the spread.
Here’s the P&L:
Maximum loss (always) equals initial debit, or $260.
Maximum gain is the difference between the strikes, times 100, less the debit, or $140 [($17 – $13) x 100 less $260].
Happy hunting!
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