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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.

Terry's Tips Stock Options Trading Blog

June 21, 2017

Is Alibaba (BABA) Ready to Accelerate Higher?

This week we are featuring an option trading idea based on a stock on the IBD Top 50 List that just delivered robust earnings guidance. We have added this spread to the Terry's Tips portfolio which trades vertical credit put spreads on selected IBD Top 50 companies (this portfolio has gained 77% so far in 2017).

Terry

Is Alibaba (BABA) Ready to Accelerate Higher?

Alibaba, broke out to fresh all-time highs last week following better than expected financial results both on the top and bottom line. Prices have been forming a bull flag pattern which is a pause that refreshes higher.

If you concur with the views expressed by these analysts, consider making this trade which is a bet that BABA will continue to advance (or at least not decline very much) over the next five weeks:

What impressed investors even more than the company’s financial result, was the company’s forward . . .

June 20, 2017

Is Arista Networks (ANET) Ready For An Acceleration To The Upside?

This week we are featuring another option trading idea based on a selection from Investor’s Business Daily (IBD) Top 50 List. I hope that it is of interest to you.

Terry

Is Arista Networks (ANET) Ready For An Acceleration To The Upside?

Arista Networks is up 56.3% YTD and recently published articles indicate the stock is poised for more upside. Here are two of them - With legal risks fading, Barclays raises Arista Networks target and Needham: 100G upgrade cycle is a boon for Arista Networks.

If you concur with the views expressed by these analysts, consider making this trade which is a bet that ANET will continue to advance (or at least not decline very much) over the next five weeks:

Buy To Open ANET 21Jul17 145 puts (ANET170721P145)

Sell To Open ANET 21Jul17 150 puts (ANET170721P150) for a credit of $1.80 (selling a vertical)

June 12, 2017

Will Nvdia (NVDA) Continue Its Upward Momentum?

This week we are discussing another of Investor’s Business Daily (IBD) Top 50 List companies. In one of our portfolios, we use this list to find stocks which have displayed a strong upward momentum, and we place spreads which will profit if the upward momentum continues for about six more weeks. Actually, the stock can even fall a little for the maximum gain to be made on these spreads.

Terry

Will Nvdia (NVDA) Continue Its Upward Momentum?

Several articles have recently been published on the positive outlook for NVDA. Here are two of them - Nvidia: Citigroup Analyst Thinks The Stock Can Go To $300 and BofAML pushes Nvidia to new price target high; shares up 2.7%.

If you agree with these analysts, you might consider making this trade which is a bet that NVDA will continue its upward momentum (or at least not decline very much) over the next six weeks:

Buy To Open NVDA 21Jul17 145 puts (NVDA170717P145)

Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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Tastyworks is a new brokerage firm from the brains behind tastytrade and it is our top choice of options-friendly brokers. Their commission rates are extremely competitive - options trades are only $1 per contract to open and $0 commission to close (all options trades incur a clearing fee of $0.10 per contract). The tastyworks trading platform quickly became our favorite platform for options trading and it keeps getting better with new features released each week. Terry uses tastyworks and loves everything about them!

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