A strategy that has served as the basis of one of our most successful real-time option services is the credit spread, notes Bernie Schaeffer, options investing expert and editor of The Option Advisor.
As a quick review, a credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time but have different strike prices. For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying's market price than the purchased option and has a higher premium, resulting in a net credit. The goal of a credit spread is to retain this net credit by having both options expire worthless.
This month, we turn the credit spread inside out to focus on the debit spread. The debit spreads we prefer are created by simultaneously buying an at-the-money, or in-the-money option and selling an out-of-the-money option on the same equity. The types of options used (puts and calls) are the opposite of what are used for credit spreads. Thus, calls are used for a bull debit spread, and puts are used for a bear debit spread.
The purchased and sold options in a bull or bear debit spread strategy are initiated simultaneously as a spread, with a net capital outlay (hence the name "debit spread"). In effect, the debit spread partially finances the purchase of an in-the-money option by selling an out-of-the-money option on the same underlying stock.
The debit spread trader anticipates that the intrinsic value (the amount by which the options are in the money) difference between the two options will widen to the point that it equals the difference between the strike prices of the options. The difference in the strike prices represents the maximum value of the debit spread.
A debit spread is an excellent way to reduce net capital outlay and lower risk, while still attempting to achieve healthy returns. The primary advantage of this more consistent trading approach is that it benefits from time decay in the sold option. That is, the time value that is included in the pricing of the written option will decrease as the option's expiration date approaches.
Another advantage is that the expected move in the underlying stock does not have to happen as quickly with this strategy, compared to the straight purchase of a call or put. In exchange for this reduced risk, potential returns are capped, which is the relative disadvantage compared to the purchase of a straight put or call.
The debit spread approach provides a less volatile risk/return profile, while still maintaining meaningful profit potential in up, down, or slowly trending markets. Note that debit spreads require an equity move in the right direction to be profitable, whereas credit spreads can remain profitable even if the underlying moves slightly against expectations. On the other hand, debit spreads generally provide greater returns.
Let's look at a hypothetical bullish debit spread trade. With stock XYZ trading at $62, the in-the-money 60 call is purchased at $3 and the out-of-the-money 65 call is sold at $1 for a debit of $2. The maximum spread value is the difference in strike prices, or $5 (65 - 60), producing a maximum spread profit of $3 (maximum spread value minus the initial debit) and a potential return of 150%.
Assume the stock moves substantially in our favor, closing at $68 on the day of expiration. To close the spread, the 60 call is sold (collecting 8 premium points) and the 65 call is repurchased (paying 3 premium points). The net premium received is $5 (8-3), which yields the maximum profit of $3 ($5 in maximum value minus $2 debit).
The value of the spread at expiration is capped at $5 (the difference between the two call strikes at all stock prices at or above $65). Likewise, the maximum loss is capped at the initial debit paid ($2) at all stock prices at or below $60, the strike of the purchased call. The breakeven point ($62) is reached when the difference in intrinsic values of the options equals the debit paid.
