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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

December 11, 2017

Floor & Decor Holdings (FND) Is Set To Grow

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 spot outperforming stocks and place spreads that take advantage of the momentum. The 10 actual option portfolios carried out by Terry's Tips for its paying subscribers have gained an average of 108% for 2017. This is down a little from a few weeks ago because many of the tech stocks that we trade options on have fallen over the past few weeks. We are still pleased with the composite results, however. (One of our newest portfolios adds the Trading Idea of the Week that we send out to you each week to its holdings).

Terry

Floor & Decor Holdings (FND) Is Set To Grow

Investors are optimistic about the outlook for FND after a recent Moody’s upgrade and an upgrade from Zacks Investment Research to a buy rating with a $46.00 price target.

December 5, 2017

Will Essent Group (ESNT) Continue the Momentum?

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 portfolios to spot outperforming stocks and place spreads that take advantage of the momentum.

Terry

Will Essent Group (ESNT) Continue the Momentum?

Essent Group has received a lot of attention as of late and several analysts are expecting more upside in the stock price. Here are two of them – Essent Group Earns Outperform Rating from Analysts at Wells Fargo & Company and Zacks: Analysts Anticipate Essent Group Ltd. Will Announce Earnings of $0.77 Per Share.

ESNT has recently seen a pickup of upside momentum after a . . .

November 20, 2017

Facebook (FB): Time to Buy The Dip?

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 portfolios to spot outperforming stocks and place spreads that profit if the momentum continues, at least a little.

The last 12 ideas which we have published here which have expired resulted in 11 gains averaging 39% (including the loss which was only 10% on one of the spreads). If you had invested the same amount in each of the 12 ideas, you would have made 468% on that amount. Of course, we can’t promise that future results will be this great.

Terry

Facebook (FB): Time to Buy The Dip?

Several analysts are expecting Facebook stock to continue higher, here are two of them – Facebook Inc Stock Can Still Deliver Value, Event at These Levels and Three stocks to buy on recent weakness.

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!

TD Ameritrade

This Chicago brokerage firm with the unlikely name thinkorswim, Inc. by TD Ameritrade is considered by many to be the best option-friendly broker. For openers, they have extremely good analytic software and their option trading platform is exceptional. Thinkorswim Mobile has been called the best mobile app in the industry. In 2017, TD Ameritrade received 4 stars out of 5 in the annual Barron`s* Best Online Brokers Survey. TD Ameritrade was tops as an online broker for long-term investors and for novices. The company is the only broker that receives the highest 5.0 score for research amenities among all firms participated in the ranking last year.

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