Debit Spreads Explained: Call & Put Debit Spreads Definition and Example

In the trading world, the term “debit spread” refers to any spread in which the trader/investor is required to outlay net premium in order to initiate the position.

That means the total premium of any purchased options will be greater than the total premium of any sold options, thus resulting in a net “debit” to the investor/trader’s account. 

In short, a debit spread requires the investor/trader to pay out more than what’s taken in when initiating the spread. In comparison, a “credit spread” results in a net credit - the premium collected from the sold options is greater than the premium paid for any purchased options.

In this context, the term "debit" refers to the initial cost to set up the spread - you'll pay more for the option you're buying than you'll receive for the option you're selling. This results in a net debit, or an initial outlay of money from the investor/trader’s account. 

Debit Spread Overview 

• Cost Structure: Requires an initial outlay of cash (debit) to establish the position.

• Directional Bias: Generally used when you have a moderate directional bias (bullish or bearish) on the underlying asset.

• Profit and Loss: Maximum loss is limited to the initial debit. Maximum profit is also capped.

• Volatility: Benefits from an increase in implied volatility, although the effect is usually small since a spread involves buying and selling options.

How Debit Spreads Work

• Buy an Option: Start by buying an option with a specific strike price.

• Sell an Option: Simultaneously, you sell another option of the same type, with a different strike price.

• Net Debit: The cost of setting up the spread is the premium paid for the bought option minus the premium received for the sold option.

A debit call spread is represented by any spread involving two different call positions in which the investor/trader has bought the option with the higher premium and sold the option with the smaller premium, thus resulting in a “net debit” to the trader/investor’s account.

How a Debit Call Spread Works

• Buy a Lower-Strike Call: Start by buying a call option with a lower strike price. This is the more expensive of the two options and establishes your right to buy the underlying asset.

• Sell a Higher-Strike Call: Simultaneously, you sell a call option with a higher strike price. This option is less expensive and partially offsets the cost of the first call option.

• Net Debit: The difference in premiums between the bought and sold options results in a net debit, meaning you'll pay more for the lower-strike call than you'll receive for the higher-strike call.

A debit put spread is represented by any spread involving two different put positions in which the investor/trader has bought the option with the higher premium and sold the option with the smaller premium, thus resulting in a “net debit” to the trader/investor’s account.

How a Debit Put Spread Works

• Buy a Higher-Strike Put: Start by buying a put option with a higher strike price. This is the more expensive of the two options and gives you the right to sell the underlying asset at that higher strike price.

• Sell a Lower-Strike Put: Simultaneously, you sell a put option with a lower strike price. This option is less expensive and partially offsets the cost of the first put option.

• Net Debit: The difference in premiums between the bought and sold options results in a net debit, meaning you'll pay more for the higher-strike put than you'll receive for the lower-strike put.

A bull call spread is an example of a debit call spread, and is typically used when a trader/investor expects a moderate increase in the price of the underlying asset. 

A bull call spread involves buying and selling call options with the same expiration date but different strike prices, as outlined in the example below.

Long Call Vertical Spread Example

• Buy: A call option on Stock XYZ with a $50 strike price, costing $5 per share (or $500 for one contract of 100 shares).

• Sell: A call option on Stock XYZ with a $55 strike price, receiving $3 per share (or $300 for one contract of 100 shares).

• Net Debit: The net debit for establishing this bull call spread would be $5 - $3 = $2 per share (or $200 for one contract of 100 shares).

Other Long Call Vertical Spread Considerations

• Advantages: One major advantage is cost reduction. Buying a call option outright can be expensive, but by selling the higher-strike call you can offset some of this cost. The maximum loss is also limited to the initial debit paid.

• Disadvantages: The profit potential is capped. The most you can make is the difference between the two strike prices minus the net debit. So, in the above example, your maximum profit would be $5 (difference between $55 and $50) - $2 (net debit) = $3 per share (or $300 for one contract of 100 shares).

A bear put spread is an example of a debit put spread, and is used when a trader/investor expects a moderate decrease in the price of the underlying asset. 

A bull put spread involves buying and selling put options with the same expiration date but different strike prices, as outlined in the example below.

Long Put Vertical Spread Example

• Buy: A put option on Stock XYZ with a $50 strike price, costing $5 per share (or $500 for one contract of 100 shares).

• Sell: A put option on Stock XYZ with a $45 strike price, receiving $2 per share (or $200 for one contract of 100 shares).

• Net Debit: The net debit for establishing this bear put spread would be $5 - $2 = $3 per share (or $300 for one contract of 100 shares).

Other Long Put Vertical Spread Considerations

• Advantages: One major advantage is cost reduction. Buying a put option outright can be expensive, but by selling the lower-strike put you can offset some of this cost. The maximum loss is also limited to the initial debit paid.

• Disadvantages: The profit potential is capped. The most you can make is the difference between the two strike prices minus the net debit. So, in the above example, your maximum profit would be $5 (difference between $50 and $45) - $3 (net debit) = $2 per share (or $200 for one contract of 100 shares).

In options trading, both debit spreads and credit spreads are used to take advantage of specific market conditions, but they operate on different principles, and have different risk-reward profiles, as outlined below.

Initial Cash Flow

Debit Spread: When you set up a debit spread, you pay an initial outlay of cash, or "debit," to open the position. In other words, you're spending money upfront.

Credit Spread: In contrast, a credit spread gives you an initial inflow of cash, or "credit." You actually receive money when establishing the position.

Directional Bias

Debit Spread: This strategy is generally used when you have a moderate directional bias on the underlying asset. You expect the price to go up (bullish) or down (bearish), but not dramatically.

Credit Spread: Credit spreads are usually implemented when you have a neutral outlook on the asset or expect it to move only slightly against your position. You're essentially betting that the asset price will stay within a certain range.

Profit and Loss

Debit Spread: Both your maximum profit and maximum loss are capped. Your maximum loss is limited to the initial amount you paid to establish the spread.

Credit Spread: Your maximum profit is also capped, limited to the initial credit you received. Your maximum loss, while capped, is generally higher than your maximum potential profit.

Volatility and Time Decay

Debit Spread: Debit spreads can benefit from an increase in implied volatility, but the effect is often small since you're both buying and selling options. Time decay works against you because you've outlaid a net premium to establish the spread. 

Credit Spread: Credit spreads benefit from a decrease in implied volatility and also from time decay. As time passes, the options you sold will lose value, which is good for you since you are a net seller of premium. 

In order to trade a debit spread, investors and traders can follow these general guidelines: 

Asset Selection: Choose the underlying asset you're interested in. Make sure you have a directional view on the asset—either bullish for call spreads or bearish for put spreads.

Strike Prices: Decide on the strike prices for both the option you will buy and the one you will sell. The difference in strike prices will determine your potential profit and loss.

Expiration Date: Choose an expiration date for both options. Both must have the same expiration date to form a spread.

Risk/Reward Analysis: Calculate the maximum possible profit and loss to make sure the risk-to-reward ratio aligns with your trading objectives.

Open the Position: This can often be done as a single transaction known as a “spread order.” Make sure you are paying the net debit that you calculated, or that fits within your acceptable range.

Monitor and Adjust: Keep an eye on the underlying asset’s price, as well as changes in volatility and time decay. These factors will impact the value of your spread. If your view on the asset changes, you may choose to adjust the trade, although this can entail additional costs.

Close the Position: You can close a debit spread position by doing the opposite of your initial trade. That means buying back the option you initially sold and selling the option you initially bought. You may also elect to let the options expire if they are in a profitable position, depending on your outlook and risk tolerance. 

In the trading world, the term “debit spread” refers to any spread in which the trader/investor is required to outlay net premium in order to initiate the position.

That means the total premium of any purchased options will be greater than the total premium of any sold options, thus resulting in a net “debit” to the investor/trader’s account. 

In short, a debit spread requires the investor/trader to pay out more than what’s taken in when initiating the spread. In comparison, a “credit spread” results in a net credit - the premium collected from the sold options is greater than the premium paid for any purchased options.