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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 16, 2017

Consider Five Below Inc (FIVE) After The Bullish Technical Breakout

This week we are featuring another of the Investor’s Business Daily (IBD) Top 50 List companies. We use this list in one of our portfolios to identify outperforming stocks and place spreads that take advantage of the momentum.

The composite average gain for the 10 portfolios carried out for Terry's Tips paying subscribers has now reached 95.2% for 2017. Isn’t it time for you to come on board and learn exactly how our options strategies have been able to compile this kind of record so consistently this year?

Terry

Consider Five Below Inc (FIVE) After The Bullish Technical Breakout

Several analysts have been praising Five Below Inc’s business model and see further upside in the stock price. Here are two of them – Five Below Might Offer 15% Upside Potential and Amazon Who? This Fast-Growing, Teen-Focused Retailer Breaks Out.

Recently, there has been a technical breakout in FIVE as it has scaled above the 2016 and 2017 highs which were in close proximity of each other around the $53 price point. The stock has also climbed above a horizontal level at $54.77 which was major resistance in 2013, in doing so, the stock briefly traded at record levels. There has been a retracement in the past week which could be offering an attractive entry point.

October 9, 2017

Will the Nvidia (NVDA) Bull Run Continue?

This week we are discussing another of the Investor’s Business Daily (IBD) Top 50 List companies. We use this list in one of our portfolios to identify stocks with upward momentum and place spreads which will profit if the upward momentum continues for about four weeks. Actually, the stock can even fall a little for the maxium gain to be made on these spreads.

The actual portfolios carried out for Terry's Tips’s paying subscribers had another banner week, gaining an average of 4.7% while the market (SPY) rose 1.2%. Our 10 portfolios have now gained 86.7% so far in 2017. Options clearly can deliver extraordinary gains if they are set up properly.

Terry

Will the Nvidia (NVDA) Bull Run Continue?

Nvidia stock has gained significantly over the last year and several analysts believe there is further upside. Here are two of them – Buy Nvidia, market’s hottest stock, on its gaming, A.I. prowess: Citi and 14% Upside Seen For Nvidia Shares On PC Gaming, Bitcoin Mining Strength.

From a technical perspective, NVDA has been rallying in a rising trend channel since early July. There was a correction that took place late ...

October 2, 2017

Earnings Growth To Fuel Further Momentum For Red Hat (RHT)

This week we are featuring a recent addition to the Investor’s Business Daily (IBD) Top 50 List of companies. We use this list in one of our portfolios to spot outperforming stocks and place spreads which will profit if the upward momentum continues. Actually, the stock can even fall a little for the maximum gain to be realized on these spreads.

The 10 Terry's Tips option portfolios enjoyed another stellar week last week, gaining an average of 1.2%, and making the ytd number a whopping 78% for all the portfolios combined. This is over 7 times as great as the 2017 results for the market (SPY) which is up about 11%.

Terry

Earnings Growth To Fuel Further Momentum For Red Hat (RHT)

Red Hat reported above-consensus earnings in the past week and several analysts have refreshed their upside targets since. Here are two of them – Red Hat PT raised to $128 at BMO Capital and Red Hat PT Raised to $117 at JPMorgan Following 2Q.

Red Hat’s earnings report triggered a push higher above a notable horizontal level at $108.04 that held the stock price lower on several attempts throughout the month prior to the report. RHT also regained the 20-period daily moving average on the back of the same surge and hit fresh 52-week highs. The horizontal level and the moving average fall in close proximity to each other, offering a strong confluence of downside support.

Making 36%

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

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