Credit spread strategies have a strong following for obvious reasons. A main component of option premium is time, and option traders would rather have time on their side. Indeed, credit spreads are constructed to take greater advantage of this time decay. In addition, credit spreads may be designed to have a high probability of success. However, with the high probability comes a relatively low reward compared to the significantly higher maximum loss potential.
Credit spreads involve selling the higher-priced option and buying the cheaper option for protection. This has the psychological advantage of starting off net-positive in terms of premium. Debit spreads involve buying the higher-priced option and selling the cheaper option. The most that can be lost on the debit spread is the amount that was paid. Because of this reason, debit spreads are considered to be a more conservative strategy vs. a credit spread.
Here, we’ll take a closer look at bullish and bearish vertical debit spreads. For these spreads to profit, the underlying stock will have to gain or lose value accordingly, making vertical debit spreads a directional strategy.
Pros & cons
The first advantage of a vertical debit spread is cost. It is less expensive than buying in-the-money (ITM), at-the-money (ATM) or just slightly out-of-the-money (OTM) options.
This advantage is all too clear, especially for expensive options with high implied volatility that usually accompany high-priced stocks. Google (GOOG) is a relatively high-priced stock by most traders’ standards, and the options can be very expensive as well. If a vertical spread is implemented in which options are both bought and sold, the cost of the trade can be reduced dramatically.
The stocks and options don’t necessarily have to be expensive to use a vertical debit spread. The benefits can be utilized for cheaper stocks and options as well.
A disadvantage of lowering the cost with a vertical debit spread is that maximum profit is defined and capped. With long options, maximum profit is theoretically unlimited. With a vertical debit spread, the maximum profit is capped by the option that was sold. No matter how much the stock moves past the sold strike, the option buyer most likely will exercise the right to buy or sell the stock at the strike price, negating further gains.
Another advantage of a vertical debit spread is that if the underlying stock moves counter to the position, the spread will lose less than a straight call or put because of a smaller delta and initial costs.
The trade’s delta is smaller because the positive larger delta of the long option is offset partially by the smaller negative delta of the short option. For example, say XYZ stock is trading at $40 a share, and an option trader purchases an ATM call option (40) with a delta of 0.50. For every dollar XYZ goes up or down, the call option should increase or decrease by 50¢. If a vertical spread were created by selling a call with a strike price of 45 and delta of 0.20, the delta for the spread would now be 0.30 (0.50 - 0.20). Now the spread would gain or lose 30¢ for every dollar the stock went up or down.
Delta will increase the closer the options get to expiration. The more an option is ITM, the larger the delta will be. Of course, the downside to lowering the overall delta is obvious. If the trader is correct on the movement and the stock never hesitates, more profit could be made just by being long the option.
Upside opportunity
The cost and the profit potential of the trade are dependent on a couple of factors. The strike price of the long call option is probably the biggest contributor. If the long option is OTM, the price will be cheaper than an ATM or ITM option. The lower cost of the long option means the spread’s cost is lower, which in turn means more maximum profit potential.
The disadvantage of buying the option farther OTM is that the underlying stock has to change in price more to reach the maximum profit potential. The closer the long option strike is to being ATM, or further ITM, the more expensive the spread will be. ATM or ITM options always are going to be more expensive than OTM options. If ATM or ITM options are bought, the spread will be more expensive, which lowers the maximum profit potential. On the plus side, however, the underlying stock will have to move less to reach maximum profit and surpass the sold option’s strike by expiration.
Another factor is the distance between the long and short strikes. If a shorter distance is chosen, usually the spread will cost less because the short strike will have a higher premium. Also, the stock will have to move less to reach its maximum potential because there is less distance between the strikes. If a larger distance is chosen between the strikes for a vertical debit spread, the spread will cost more; the short strike premium will be less because it is farther away from the long strike. The stock now will have to move more to reach its maximum potential, but that maximum profit will be greater, as well, because of the bigger spread between the strikes.
Bullish scenario
A bull call spread (bullish vertical debit spread) involves buying a call option and selling a higher strike call option. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The most the option trader can lose is the cost of the spread.
It’s Oct. 28 and YYY stock is trading at $94.15 per share. An option trader believes that within two months, the stock will be trading at $100 per share and might stall out there. One strategy would be a bull call spread. The trader could buy the December 95 call (a near-the-money call) with a current delta of 0.49 for $6.40 and sell the OTM December 100 call with a current delta of 0.34 for $4.40. The cost of the spread is $2 ($6.40 - $4.40). This is the most the trader can lose if the stock finishes below $95 by December expiration (see "Bull call debit spread," below).
The maximum profit potential on the trade is $3 ($5 - $2), which is the difference in the strikes minus the cost of the trade. The maximum profit would be achieved if YYY finished above $100 at December expiration. Breakeven on this trade can be calculated by adding the cost of the trade to the long call’s strike price. In this example, it’s $97 ($95 + $2) at December expiration. If the December 95 call were bought on its own, the breakeven on the trade would be $101.40 ($95 + $6.40).
Currently, the delta on the spread is 0.15 (0.49 – 0.34), which means the trade will make or lose 15¢ for every dollar the stock goes up or down. Initially, it can be a disadvantage, but if the stock declines, the trader will lose less on the spread than by just being long the calls. As the options get closer to expiration, the delta on the spread will widen. However, the goal of the trade remains the same: For the stock to trade over the sold call’s strike by December expiration.
Bearish scenario
A bear put spread (bearish vertical debit spread) involves buying a put option and selling a lower strike put. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The most the option trader can lose is the cost of the spread.
It’s Oct. 25 and ZZZ stock is trading at $318.50 a share. An option trader believes the stock is overbought and might decline over the next month. The options are pretty expensive, and the trader worries that the stock might keep rising, so a bear put spread makes sense. The trader can buy the November 315 put (just OTM) with a current delta of 0.44 for $9 and sell the OTM November 305 put with a current delta of 0.28 for $5.25. The cost of the spread is $3.75 ($9 – $5.25), which is the most the trader can lose if the stock finishes above $315 by November expiration (see "Bear put debit spread," below).
The maximum profit potential on the trade is $6.25 ($10 - $3.75), which is the difference in the strikes minus the cost of the trade. This would be achieved if ZZZ finished below $305 at November expiration. Breakeven on this trade can be calculated by subtracting the cost of the trade from the long put’s strike price. In this example, it’s $311.25 ($315 - $3.75) at November expiration. Just like what was shown in the bullish example, if the November 315 put were bought on its own, the breakeven on the trade would be $306 ($315 - $9), which is quite a bit more.
Currently, the delta on the spread is 0.16 (0.44 - 0.28), which means the trade will make or lose 16¢ for every dollar the stock goes up or down. Again, this can be a disadvantage, but if the stock rallies even more, which was one of the concerns, the trader will lose less on the spread than by just being long the puts.
The maximum profit goal of the bear put spread is to have the stock trading below the sold put’s strike at November expiration.
Vertical debit spreads are a relatively easy to understand and pretty straightforward option strategy. Just like any other option strategy, each has advantages and disadvantages. When deciding whether to buy just calls or puts, or to buy a vertical debit spread, the pros and cons of each have to be debated. Often, however, this analysis will come down on the side of the spread. With this strategy in your arsenal, you now can be prepared for those times.
John Kmiecik has worked for several firms, including Goldman Sachs and First Options of Chicago, and has traded professionally for hedge funds. Currently, he is an options coach for Market Taker Mentoring LLC. E-mail him at john@markettaker.com.
