Trader's Guide to Vertical Debit Spreads
The strategies and ideas presented in this guide have been designed to provide you with a comprehensive program of learning. The goal is to guide you through the learning experience so you may be an independent, educated, confident and successful trader. There are numerous variations of traditional options strategies and each has a desired outcome. Some are very risky strategies and others require a considerable amount of time to find, execute and manage positions. Spreads are a limited risk strategy.
Spreads
Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes.
Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias).
Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the same anticipated move down.
In this guide we will be talking about Vertical Debit Spreads, which are a limited risk strategy. Learning how to manage risk is as important as learning the details of a strategy.
Vertical Debit Spreads
A vertical debit spread is created when an investor simultaneously buys-to-open (BTO) one option and sells-to-open (STO) another option. The premium paid for the BTO is always greater than the premium received for the STO thus, creating a net debit from the trader’s account.
Example:
Spreads
Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes.
Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias).
Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the same anticipated move down.
In this guide we will be talking about Vertical Debit Spreads, which are a limited risk strategy. Learning how to manage risk is as important as learning the details of a strategy.
Vertical Debit Spreads
A vertical debit spread is created when an investor simultaneously buys-to-open (BTO) one option and sells-to-open (STO) another option. The premium paid for the BTO is always greater than the premium received for the STO thus, creating a net debit from the trader’s account.
Example:
- BTO a call using the May 180 strike for a debit of $7.57
- STO a call using the May 190 strike for a credit of $3.42
- Net debit for the spread is $4.15
The proper construction of a vertical debit spread is to BTO an at-the-money (ATM) strike and STO the strike that is 5 – 10 points further out-of-the-money (OTM). When opening a call debit spread, further OTM means a higher strike. When opening a put debit spread, further OTM means a lower strike.
Both legs are opened on the same underlying equity and use the same expiration month.
The Delta Ratio
Delta is a factor in how profitable a debit spread may be. When the underlying stock moves, the value of the options will change at the rate of the Delta. Delta values will be different for different strikes depending on how far out-of-the-money or in-the-money the strike is. Look at an options chain for the current expiration month. Find the Delta of the at-the-money strike and compare it to the Delta of a strike 20 points out-of-the-money. The ATM strike will always have a higher delta than the OTM strike. This means that the value of the ATM strike will change more quickly than the OTM strike, as the underlying stock moves.
When properly constructed, a debit spread is designed to take advantage of the Delta relationship between the long and short options. By STO a strike further out-of-the-money than the BTO strike, the long leg will increase in value more rapidly than the short leg. This is referred to as the Delta Ratio.
Put debit spreads are used when the stock shows a declining bias. Puts increase in value as the stock decreases in value. In this case, the long put would increase in value creating a profit. The short leg would increase in value creating a loss. However, as we learned earlier, due to the Delta Ratio, the long put is increasing in value faster than the short put is creating a loss. This will create an overall position profit as the stock moves down.
Here is an example: Stock trading at 520 and has a declining bias. - BTO 520 put
- STO 510 put
This spread creates a debit of $4.80
Stock declines to 510 causing the values of the puts to increase. The position can now be closed for a profit. - STC 520 put
- BTC 510 put
The value of the spread has increased to $5.80. Since the stock declined in value, the put options are more expensive.
The spread was BTO for a debit of $4.80 and STC for a credit of $5.80 resulting in a $1.00 profit.
Call debit spreads are used when the stock shows a rising bias. Calls increase in value as the stock rises. In this case, the long call would increase in value creating a profit. At the same time, the short call would increase in value creating a loss. However, as we learned earlier, due to the Delta Ratio, the long call is increasing in value faster than the short call is creating a loss.
Stock trading at 500 and has a rising bias. - BTO 500 call
- STO 510 call
This spread creates a debit of $4.80
Stock rises to 510 causing the values of the calls to also rise. The position can now be closed for a profit. - STC 500 call
- BTC 510 call
The value of the spread has increased to $5.80. Since the stock increased in value, the call options are more expensive.
The spread was BTO for a debit of $4.80 and STC for a credit of $5.80 resulting in a $1.00 profit.
Risk and Reward on Vertical Debit SpreadsReward
The maximum profit that can be earned from a vertical debit spread is equal to the width of the spread minus the cost of opening the spread. For a vertical debit spread to realize the maximum potential profit, both legs of the spread would need to expire in-the-money which means the position would need to be held until expiration.
I do not recommend holding positions until expiration. Short term movements in the stock/index plus limited time value decay provide opportunities to close out positions for a profit of about 10%. If a position is profitable and the trader decides to hold the position hoping for a bigger profit or in an attempt to carry the position to expiration, there is a good chance that the profit will disappear and the position could turn into a losing position. This also will increase the risk of assignment/exercise if trading an American style expiration.
A good way to lose money is to wait for a bigger profitRisk
The maximum risk, or potential loss, from a vertical debit spread is the net debit (cost basis) of the spread (BTO leg debit minus the STO leg credit).
Example: - BTO 2765 call for a debit of $11.70
- STO 2770 call for a credit of $8.30
- Cost basis of the spread is $3.40
- $3.40 is the maximum risk.
A maximum loss will occur when both strikes are out-of-the-money at expiration. Learning how to properly adjust positions will avoid this.
A trader establishes a bullish (call) debit spread when the chart indicates a rising bias. The breakeven point is the lower strike price plus the net debit. Referring to the example above, if the stock was at 2768.40 at expiration, there would be no loss and no profit.
Example of breakeven point on above debit spread: - Stock settles at 2768.40 at expiration
- The 2765 strike is $3.40 ITM, the value of the strike has $3.40 of intrinsic value and no time value.
- The 2770 call expires OTM worthless and you keep the 8.30 of credit as profit.
- Since you do not want to exercise your right to own the stock, you sell the 2765 back at the price of $3.40. This results in a $8.30 loss. $11.70 BTO – $3.40 STC = $8.30 loss
- You get to keep the original credit of $8.30 from the 2770 call. This netted against the $8.30 loss results in breaking even on the position.
A trader establishes a bearish (put) debit spread when the chart indicates a rising bias. The breakeven point is the BTO (higher) strike price minus the net debit.
Calculating the Return
The profit percent return is calculated by dividing the profit by the risk. After all, if the trade lost 100% of the risk that is the amount the trader would no longer have. In the example above, the net risk is $3.40. If the debit vertical spread trade resulted in a $1.00 profit, the percentage return would be 29.41% ($1.00 / $3.40). Lower risk drives higher returns relative to capital at risk.
American vs European Style Options
Most stocks and ETF’s are American style options. This means that if the buyer of an option chooses to exercise or assign their rights they may do so at any time prior to expiration.
Indexes such as SPX, NDX, and RUT are European style options. This means that any exercise or assignment may only occur at expiration.
Trading spreads on European style options, can alleviate the concern of early exercise/assignment. If both legs are ITM, they can only be exercised or assigned at expiration, which allows flexibility to continue to hold the position rather than take action to avoid assignment/exercise as would be suggested on American style options.
Opening a new Put Debit Vertical SpreadThe following steps should be referred to when opening a new put debit vertical spread position:1. Review the technical indicators on your chart and confirm there is a consensus between multiple indicators pointing to a declining bias.
2. Select an expiration that is one to three months out. One month is generally the minimum time to expiration you want to use. Building time into the position is advised in case it needs to be managed. The sweet spot for opening new positions is two months to expiration.
3. BTO the at-the-money (ATM) put strike. BTO the strike that is closest to the money. When the stock/index is trading between strikes, BTO the first strike higher than the current price of the stock.
4. STO the strike that is 10 points further out-of-the-money (OTM). With a put spread, further OTM means a lower strike.
BTO ATM and STO 10 points further OTM will create a debit. Generally, when properly constructed, the debit will be in the range of $4.00 - $6.00.
5. When placing the order, always use a Limit order. A limit order specifies to the market the amount of the debit you will accept. A limit order will be filled at the specified limit or lower. Market orders should not be used.
6. With some stocks and indexes, the difference between the bid and ask is quite large. The broker will usually give you a quote called the “Mark”. This is the midpoint between the bid and ask. It is the price you should start with when submitting your limit debit order.
7. Calculate the risk of the position. Cost basis of position is risk. So a position with a debit of $4.50 would have a risk of $4.50.
8. Use the risk number to determine the number of contracts to open. Risk x 100 = the investment required for each contract. With $4.50 of risk and one contract, the total investment would be $450 ($4.50 x (1 contract x 100 shares per contract)).
9. Once you know the total investment required per contract, you can decide how many contracts to trade based on the size of your portfolio. Generally, allocating 5% of the total portfolio to each trade is good risk management. Smaller account sizes may require a higher investment per trade but should not exceed 10%.
10. After the trade has been opened, place a Good-til-Canceled (GTC) order to close the position for a $1.00 profit. A GTC order will stay active until market conditions are such that the position can be closed for a $1.00 profit. GTC orders execute automatically and do not require you to be in front of your computer to take advantage of the profit opportunity.
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