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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

October 17, 2021

No Progress Here


Amid
the giddiness over solid earnings from the big banks, you may have missed the
lousy earnings report from insurance giant Progressive (PGR) on Thursday
morning. Earnings plunged 90% from a year ago and fell 10% shy of estimates.
Revenue came up a billion dollars short of expectations. The company also swung
to a loss in September due to payouts for Hurricane Ida. Analysts apparently
weren’t paying attention, as there were no upgrades, downgrades or target price
changes issued after the news.





The
stock didn’t do much after the report, falling less than a percent on Thursday.
On Friday, the shares gained that all back – and more – and closed right on
their declining 20-day moving average. Despite the rebound, PGR has been
trading sideways for three weeks after suffering a 6.2% drop in September that
was guided by the 20-day. All relevant moving averages sit at or above the
stock price, ready to lend resistance. We are therefore playing a bearish call
credit spread with the short call sitting above PGR’s 20-day moving average.





If
you agree that PGR will struggle with its 20-day moving average (blue line in
chart) line in chart), consider the following trade that relies on the stock
remaining below 92.5 (red line in chart)  (through expiration in five weeks.









Buy
to Open PGR 19Nov 95 call (PGR211119C95)

Sell to Open PGR 19Nov
92.5 call (PGR211119C92.5) for a credit of $0.80 (selling a vertical)





This
credit is $0.05 less than the mid-point
of the option spread when PGR was trading at $91.25. Unless the stock falls
quickly from here, you should be able to get close to this amount.





Your
commission on this trade will be only $1.30 per spread.  Each spread would then yield $78.70. This trade
reduces your buying power by $250 and makes your net investment $171.30 ($250 –
$78.70).  If PGR closes below $92.50 on
November 19, both options will expire worthless
and your return on the spread would be 46% ($78.70/$171.30).


October 11, 2021

Not Cloudy for Oracle


Cloud
infrastructure and software provider Oracle (ORCL) has been weathering the
market’s recent storm better than most. While the broader market has struggled
since the start of September – the S&P 500 is down 3% - ORCL has thrived,
gaining 6%. In fact, the stock closed at a record high on Friday. That move
pushed the shares above the top of a trading range between 85 and 92 that has
been in place since early July.





ORCL’s
recent earnings report on Sept. 13 was in line or beat both analyst estimates
and guidance. The stock dropped 3% the day after the report, which is typical
of the stock’s post-earnings performance. So is the subsequent strong recovery,
as ORCL is up 9% since the initial drop.





Likely
helping the cause were a few target price increases. It’s notable that analysts
may be jumping on ORCL’s bandwagon. In September, just six of 30 (20%) covering
analysts rated ORCL a buy or better. Today, 26 of 36 analysts (72%) are in the
bullish camp.





We are playing a bullish put credit spread with the short put sitting just above ORCL’s 50-day moving average. This trendline will likely beak above the short strike at 90 in the next few days based on the stock’s recent strength.









If
you agree that ORCL will stay above 50-day moving average ( (blue line in
chart) line in chart), consider the following trade that relies on the stock
remaining above 90 (red line in chart)  (through
expiration in six weeks.





Buy
to Open ORCL 19Nov 87.5 put (ORCL211119P87.5)

Sell to Open ORCL 19Nov
90 put (ORCL211119P90) for a credit of $0.45 (selling a vertical)





This
credit is $0.03 less than the mid-point
of the option spread when ORCL was trading above $94. Unless the stock rises
quickly from here, you should be able to get close to this amount.





Your
commission on this trade will be only $1.30 per spread.  Each spread would then yield $43.70. This
trade reduces your buying power by $250 and makes your net investment $206.30
($250 – $43.70).  If ORCL closes above
$90 on November 19, both options will expire worthless
and your return on the spread would be 21% ($43.70/$206.30).


September 20, 2021

A Salesforce to be Reckoned With


As
its ticker symbol implies, Salesforce.com (CRM) provides cloud solutions for
customer relationship management needs. CRM reported earnings in late August
that blew away expectations on both the top and bottom lines. The report was
met by the usual round of target price increases that reached as high as $340
(CRM closed at $260 on Friday).





The
stock gapped higher after the report and extended as much as 5.5% higher the
next day, eventually closing with a 2.5% gain. But the shares then sagged,
joining the rest of the market in the early-September swoon. In fact, CRM fell
more than 8% from its post-earnings high.





But the shares appeared to find a bottom last week, thanks to the support of the 50-day moving average. Since turning higher in May, the 50-day has supported pullbacks in July and August. CRM has been stepping higher since a low in early March, putting in a series of higher highs and lows in a rally that has covered nearly 30%. This trade is relying on this trendline support holding for the next six weeks, as the short 250 put of our credit spread is just below the 50-day.









If you agree that CRM will stay above the 50-day moving
average (blue line in chart), consider the following trade that relies on the
stock remaining above 250 (red line in chart) through expiration in six weeks.





Buy to Open CRM 29Oct 245 put
(CRM211029P245)

Sell to Open CRM 29Oct 250 put (CRM211029P250) for a credit
of $1.10 (selling a vertical)





This credit is $0.02 less
than the mid-point of the option spread
when CRM was trading at $260. Unless the stock rallies quickly from here, you
should be able to get close to this amount. Your commission on this trade will
be only $1.30 per spread.  Each spread
would then yield $108.70. This trade reduces your buying power by $500 and makes
your net investment $391.30 ($500 – $108.70). 
If CRM closes above $250 on October 29, both options will expire worthless and your return on the spread would
be 27% ($108.70 / $391.30).


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