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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

September 23, 2018

Consider Buying the Post-Earnings Dip in Adobe Systems (ADBE)

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

Terry

Consider Buying the Post-Earnings Dip in Adobe Systems (ADBE)

Adobe’s stock price has seen a steady rise over the last few years, and from both a technical and fundamental standpoint, there is a strong case to be made that it will continue.  These following two articles discuss the recent earnings report and where the stock may go from here - Adobe: Stock Marches Forward With Another Record Quarter and Should You Buy Adobe Systems at Its All-Time High?.  As well, there have been several price target upgrades as of late and a few of the more bullish analysts think the stock can even cross above the $300 price point.

September 15, 2018

Has Netflix (NFLX) Found A Bottom?

This week we are looking at another of the Investor’s Business Daily (IBD) Top 50 List companies.  We use this list in one of our options portfolios to spot outperforming stocks and place option spreads that take advantage of the momentum.  The actual portfolio that Terry’s Tips carries out with these plays we send to you each week has gained 98.5% so far this year.  We started out 2018 with $5000 in the portfolio and withdrew that amount in June so that subscribers who mirrored it in their own account or had trades executed for them with the free Auto-Trade service at thinkorswim have almost $5000 left and it is entirely profits for them.

Terry

Has Netflix (NFLX) Found A Bottom?

Despite a recent correction, market sentiment towards Netflix stock remains positive while certain analysts see a notable upside from current levels.  Take a look at this recent article posted on Investopedia that states a 30% rally could be in the cards for NFLX and the following article posted on Seeking Alpha that builds a strong case for remaining bullish.

September 10, 2018

Mastercard (MA) Expected to Continue the Steady Rise

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

The actual Terry’s Tips portfolio which trades essentially every weekly play that we send to you has gained 91% so far this year (after paying all commissions, of course).  The portfolio started out the year with $5000, and on June 15, 2018, we withdrew $5000 from the portfolio so that all subscribers who followed it would all their money back and be playing with pure profits.  The portfolio is now worth $4552.

I especially like this week’s idea because I like Mastercard and believe that last week’s weakness in the stock price was unwarranted.  Enjoy the full report below.

Terry

Mastercard (MA) Expected to Continue the Steady Rise

Among the list of IBD Top 50 companies Mastercard stands out as its uptrend is far steadier than any of the other companies.  These two articles suggest the stock will continue the trend – Mastercard’s Stock May Have Big Gains Ahead and Mastercard’s Strategy Suggests Further Stock Price Growth Ahead After 60% Rise.

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