It’s as if options were designed to lose. Or at least that is what it feels like if you’re straight up buying calls or puts. There are way too many variables that work against you- time, volatility, and money-ness.
Options Make It Easy To Lose Money
If you’re familiar with option Greeks (which you should be if you’re an options trader), looking at delta values can be depressing. Option traders agree that delta values reflect the probability of an option expiring in-the-money.
Options that are at-the-money near expiration typically have a delta above 0.70. That means that they have a 70% chance of expiring in-the-money. Whereas out-of-the-money options near expiration have a delta below 0.30. That means that they have only a 30% chance of expiring in-the-money.
It’s obvious that we would want to buy the at-the-money options to increase our odds of success. So what’s stopping us? The premiums of at-the-money options are usually very expensive. The big price tag keeps us away because it increases our max loss and the break even point is further away.
Here’s the good news- you can afford at-the-money options with a fancy little thing known as debit spreads.
Debit Spreads Are Like Shopping With Coupons
Debit spreads let you buy at-the-money options at a discount. You can end up getting your options at over a 50% discount! The debit spread ends up costing just as much as a far out-of-the-money option.
How does this work? It works by incorporating theta tactics. You lower the cost of the trade by selling a different option for premium to fund the trade.
Let’s say you wanted to buy an at-the-money call that costs 7.00. In order to make this more affordable, you sell a call to collect 3.50 in premium. Now the at-the-money call technically only costs you 3.50 (7.00 – 3.50 = 3.50).
In reality, debit spreads are a bit more complex than that. A debit spread needs to be constructed strategically in order to prevent unnecessary losses and to increase the probability of success.
It’s time for you to learn how to make and use debit spreads!
How To Construct A Debit Spread
Before we dive too far into debit spreads, it’s important to make sure that you understand what you are doing by buying and selling an option.
- Buying a call gives the buyer the right to buy 100 shares.
- Selling a call gives the seller the obligation to sell 100 shares.
- Buying a put gives the buyer the right to sell 100 shares.
- Selling a put gives the seller the obligation to buy 100 shares.
For more information: check out this guide for buying options and this guide for selling options.
Therefore, if you are buying a call and selling a call at the same time, you are buying the right to buy 100 shares at one price and the obligation to sell 100 shares at another price.
Picking The Strikes For Your Debit Spread
With that in mind, it should be obvious that you would sell a call at a higher strike price than the call you bought. The opposite is true for puts- you would sell a put at a lower strike than the put you bought.
For example:
You want to buy an at-the-money call for XYZ with a strike of 100 that is trading for 5.00. The call you sell will need to have a strike that is higher than 100. So you decide to sell a call with a strike of 110 for 2.50. The entire trade costs you 2.50 (or $250)
Here is why you need to sell a call strike that is higher:
XYZ is Trading at 113 at expiration. This means that both your long call and short call are in-the-money. Both of your options get exercised.
- Your long call gets exercised and you buy 100 shares of XYZ at a trade price of 100.
- Your short call gets exercised and you sell 100 shares of XYZ at a trade price of 110.
A little bit of math is needed to figure out the profit of your debit spread at expiration. Let’s look at how it is done:
Calculating The Profit Of A Debit Spread
The profit of a debit spread is calculated by measuring the difference between the strikes and subtracting the cost of the trade.
Using the previous example- let’s calculate the profit of the trade.
- The debit spread cost 2.50
- You bought 100 shares at a trade price of 100
- You sold 100 shares at a trade price of 110.
The equation looks like this:
(110*100) – (100*100) – (2.50*100) = $750
Not a bad return for a $250 investment! That’s a 300% return!
Risks Of Debit Spreads
There are not many risks associated with debit spreads. For the most part, the risks are fairly similar to buying long options. Although, there are two important things to keep in mind when trading debit spreads.
Those two things are: your max loss and what happens if you pick the wrong strikes when constructing your debit spread.
Max Loss Explained
Realizing your max loss for a debit spread is the same as realizing your max loss for a long call- your max loss is realized when the long call expires out-of-the-money.
You max loss is the debit you paid for the debit spread. So if you paid 2.50 for your debit spread, your max loss is 2.50.
This is a much better risk profile when compared to long options. Think of it this way:
In the example from earlier, the long call with the strike of 100 cost 5.00. If you would’ve only bought the long call, your max loss would’ve been $500. Instead, the short call cut your max loss in half by bringing it down to $250.
What Happens If You Pick The Wrong Strikes?
Choosing the wrong strikes will set you up for a loss. The only way you could set yourself up for a loss by accidentally creating a credit spread instead of a debit spread.
This happens when you sell an option with a strike that is closer to the money than the strike of the option you buy.
Let’s use the example from before and switch the strikes to illustrate this point:
- You sell a call with a strike of 100 for 5.00.
- You buy a call with a strike of 110 for 2.50.
- 2.50 (or $250) in premium was collected instead of paying a 2.50 debit.
This is what would happen if both strikes expired in-the-money:
- 2.50 in premium was collected.
- You sell 100 shares with a trade price of 100.
- You buy 100 shares with a trade price of 110.
Your loss would be calculated like this:
(100*100) – (110*100) + (2.50*100) = -$750
By choosing your strikes backwards, you set yourself up for a $750 loss!
The good news is that most brokers will show you the type of trade you have just set up on the confirmation screen before your order is sent. So if you see that your trade will result in a credit, cancel that order and set the strike prices properly.
Downside Of Using Debit Spreads
There is only one feature of debit spreads that turns off some traders… the fact that debit spreads have a maximum profit.
Some traders are turned off because they are in love with the idea that options have infinite profit potential. Going for that idea of infinite profit potential will cause them to risk more money, or they will have to pick a further out-of-the-money option to keep the cost of the trade small.
I don’t know about you, but I am perfectly fine with a 100%-300% max return on my investment. Especially since I know how small my risk is.
Debit Spreads have almost half the risk and it increases the odds of success!
Did you like this post? How often do you use debit spreads? What strikes do you usually pick? Make sure to let me know!