What are the characteristics of this option strategy?
Debit spreads are vertical spreads that a trader pays to open: buy one option and sell a further out of the money option of the same type and expiration, so the net cost, or debit, is lower than the maximum potential profit. Traders use debit spreads to cap the amount at risk and to target limited, defined gains. In their two common forms they are known as the bull call spread and the bear put spread.
Is this a bullish, bearish or neutral strategy?
Debit Spread Option Strategy is a directional strategy: a call debit spread profits when the underlying rises, a put debit spread profits when it falls. It is not direction-neutral, and the trader must pick a side when opening it. It can be used on stocks, ETFs and indices, but in every case the trade needs the underlying to move the right way to pay off.
Is this a beginner or an advanced option strategy?
Debit Spread Option Strategy is a moderately advanced option strategy. Though it is accessible to beginners, it requires a thorough understanding of options trading before attempting. It’s also important to understand the concepts of volatility and the Greeks before trading debit spreads.
In what situation will I use this strategy?
Debit Spread Option Strategy is typically used when a trader has a moderate directional view: a call debit spread when the outlook is moderately bullish, a put debit spread when it is moderately bearish. It suits a move that is expected to be real but not dramatic, because the short leg gives up everything beyond its strike in exchange for lowering the entry cost.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
Debit Spread Option Strategy typically rewards a smaller return but has a higher probability of success than buying the same option outright, because the premium collected on the short leg lowers the breakeven. The risk is limited to the debit paid. The profit is capped at the strike width minus that debit, so it gives up the open ended gain that holding the underlying or a single long option would offer.
How is this strategy affected by the greeks?
The Greeks (Delta, Gamma, Theta, Vega, and Rho) can all affect the debit spread strategy. Delta is the rate of change in the option’s price with respect to a change in the price of the underlying security. Gamma measures the rate of change in the delta with respect to a change in the underlying security price. Theta is the rate of change in the option’s value with respect to the amount of time left until expiration. Vega is the rate of change in the option’s value with respect to a change in volatility. Finally, Rho measures the option’s sensitivity to interest rates.
In what volatility regime (i.e VIX level) would this strategy be optimal?
A debit spread is opened for a net cost, so the trader is a net buyer of premium and generally prefers implied volatility on the low side, roughly a VIX in the teens to the low 20s, where the long leg is cheaper. Very high implied volatility raises the entry debit and therefore the amount at risk, though the short leg does offset part of that.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
When trading debit spreads, it is important to constantly monitor the positions and adjust when necessary. One way to adjust is to roll the short strike further out of the money within the same expiration, which lifts the profit cap at the cost of giving back some of the premium collected. Do not roll the short leg into an expiration later than the long leg. That turns the trade into a diagonal and leaves a short option standing on its own once the long leg expires, which removes the cap on the loss. Additionally, if the short leg is assigned early, the long leg covers the obligation, so the trader can exercise or sell the long option to close the position out at the spread width. This strategy can be quite easy to adjust, as long as one understands the basics of options trading.
Where does this strategy typically fall in the range of commissions and fees?
Commissions and fees are an important factor to consider in any option trade. Most brokers will charge a commission to open a position outside of the spread, so it is important to factor that into the equation. Debit spreads typically require less capital than other strategies, and this can help to reduce overall fees.
Is this a good option income strategy?
No. A debit spread is opened for a net payment, not a net credit, so nothing is collected up front and there is no income to book. It is a directional trade with a defined cost. Traders who want option income from selling premium use the credit spread instead, which is the same two strikes traded in the opposite direction.
How do I know when to exit this strategy?
Exiting a Debit Spread Option Strategy is usually triggered by one of three things: the spread has reached most of its maximum value with both strikes in the money, the directional thesis has broken and the trader wants to recover what is left of the debit, or expiration is close enough that the remaining time value no longer justifies holding. Waiting for the last few cents of the maximum profit rarely pays for the assignment risk of holding a short in the money call into expiration.
How will market makers respond to this trade being opened?
Market makers typically respond in a neutral manner to debit spread trades. Because the two legs largely offset each other, the net delta the market maker has to hedge is small, so the position is straightforward for them to lay off.
What is an example (with calculations) of this strategy?
Here’s an example of a Debit Spread option strategy using the stock MSFT, which is trading at $285:
Assuming that we are bullish on MSFT and believe that the stock price will increase in the near future, we could use a Debit Spread to limit our risk while still having the potential for profit. In this case, we could set up the following trade:
Buy 1 MSFT call option with a strike price of $290 for a premium of $5.00
Sell 1 MSFT call option with a strike price of $300 for a premium of $2.50
The net debit of this trade would be $2.50 per share ($5.00 minus $2.50), or $250 for one contract, and that is the maximum potential loss for the strategy. The maximum potential profit is the difference between the strike prices of the two call options ($300 minus $290 = $10), minus the net debit of the trade ($10 minus $2.50 = $7.50 per share, or $750 for one contract).
If the stock price of MSFT rises above the strike price of the short call option ($300), the short call may be assigned, and the long $290 call covers the shares that have to be delivered, so the spread simply settles at its $10 width. The maximum potential profit is realized if MSFT closes at or above the short call strike ($300) at expiration. Breakeven is $292.50 ($290 + $2.50), and at $290 or below both calls expire worthless and the trader loses the full $2.50 net debit.
MarketXLS and how it can help
MarketXLS provides a way for traders to save time, money and effort when making trades. Using MarketXLS, traders can instantly analyze Long Guts Options Strategy and Short Guts Long Guts Option Strategy. With MarketXLS, traders can make educated decisions with ease and confidence, which can lead to more profitable trades. By leveraging the power of Excel and cloud computing, MarketXLS gives traders the ability to quickly analyze market data and make profitable trades.
Here are some templates that you can use to create your own models
Call Condor Spread
Long Gut
Butterfly for Shorts Spread
Long Strangle Option Strategy
Strap Strangle
Strip Strangle
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
Maximizing Returns With a Call Debit Spread
Vertical Options Spread (Using Marketxls)
Option Strategy- Long Calendar Spread (Excel Template)
Bull Call Spread Option Strategy (Explained With Excel Template)
Bear Put Spread Option Strategy (Explained With Excel Template)