Debit Spread Options Strategy: A Guide for Beginners and Experienced Traders

In options strategy when we buy options with higher premium and at the same time we sell options with lower premium of the same underlying, expiry and quantity to gain from a directional movement is called Debit spread. As the net premium debited from our account we called it Debit Spread. The goal is to limit the risk and make some profit from the directions.

There are two types of debit spread.


Bull Call Spread  also known as Debit Call Spread. (Buying Lower Strike Call options at the same time selling higher strike call options)

Bear Put Spread, also known as Debit Put Spread. (Buying Higher Strike put options at the same time selling lower strike put options)

These two debit spread requires different technical scenario, doing mistake in this area may lead more losses than the normal.

Debit Call Spread
Debit Put Spread

Bull Call Spread or Debit Call Spread

bull_call_spread_or_debit_call_spread

A bull call spread is also known as debit call spread is a bullish options trading strategy with insurance. Buying a lower strike call options, at the same time selling a higher strike price call options of the same underlying and same expiry date. 

When the trader believe the underlying will move up but due to higher volatility options premium contain more time value, then buying only call options is risky, if traders hold it overnight then time value decay may cause loss for the buyers even if the underlying move up slowly. To survive from this outcome traders sell higher strike call option than they buy.
Long A Lower Strike Price Call Options
Short A Higher Strike Price Call Options
Same Underlying, same expiry date and equal quantitly.

Breakeven price = Strike Price of Long Call + Net premium paid
Maximum Loss = Premium Paid
Maximum Profit = Strike Difference Between Traded Options - Net Premium Paid

Technical Scenario:

When underlying price approach a higher timeframe demand zone and traders found a price action confirmation in lower time frame chart at the zone they go for Bull call spread options strategy. Or when they found a lower timeframe buying opportunity in chart pattern while there is a primary demand in higher timeframe chart. (Please note demand zone is a secondary demand, primary demand is a clear institutional buying)

More elaborately, traders do bull call spread when they found trend line breakout / morning star / hammer pattern / bullish engulfing / piercing pattern / positive divergence etc after a higher time frame demand zone.
Volatility Scenario: Underlying and or market volatility should remain high till the expiry. By chance if the volatility decreases then you may lose money faster than you expected. This volatility part is another key thing to check after technical chart.

Strike Price Selection
As per your risk tolerance and experience you can select any pairs below mentioned, but remember a small mistake to identify trend and valatility may cause more losses than your expectation.
Buy deep ITM call  Options, sell normal ITM call options.
Buy Deep ITM call Options, sell ATM call options.
Buy Deep ITM call Options, sell OTM call options.
Buy normal ITM call Options, sell ATM call options.
Buy normal ITM call options, sell OTM call options.
Buy ATM call options, sell OTM call options.
Buy ATM call options, sell far OTM call options.
Buy OTM call options, sell far OTM call options. 

Remember the more difference between two strike price, the more risk you have to afford, and yes profit potential will also increase if the direction is perfect, if the difference increases. Untill you have an excellent experience and technical analysis knowledge you should practice the popular combination of "Buying 1 strike deep ITM call options and selling ATM call options".

Assume an ABC Ltd trading at 503, and the strike difference is 10 points, so buying 480CE and Selling 500CE will be better combination if you are damn sure about the direction. 
Remember, strike selection depends on many factors, one of them is "Time remaining to expire" if more time remaining to expire then increasing the strike price difference between two call options is okey, but when expiry is near by then bigger strike price gap causes more risk.

Example: 

Assume ABC Ltd trading at 503.00 and you are bullish on it, technically a price action buying scenario occurred in lower timeframe chart at higher timeframe demand zone, you are very bullish on it but the options premium is too high. You see 490CE trading at 22, the intrinsic value of 490CE is 13/- where time value is 9/- so you are afraid that if the stock remain standstill or move up but slowly then you will lose money. So you decide to sell 500CE @ 13, intrinsic value of 500CE = 3/- and time value=10/- (As 500CE is ATM therefore the time value will be more than the ITM which is 490CE)


Let's calculate.

Long 490CE @ 22/-

Short 500CE @ 13/-

--------------------------

Net premium paid=9/-

Now we will learn to calculate the probable outcomes.
Firstly the ABC Ltd may close at lower strike price 490 on expiry, then 
The premium of 490CE will be 00, loss from this options=22/-
The premium of 500CE will be 00, profit from this options=13/-
_____________________________________________________________________
Net loss=22-13=9/-,

Now if we dont want to lose money, we must able to sell 490CE at 9/-, as we know that the premium of the options is equals to Intrinsic Value on expiry, therefore 9 should be the Intrinsic Value of 490CE, already we know that...
Intrinsic value of a Call options= Current Market Price - Strike Price
9=X-490, here X = current market price 
X=490+9
Now we can say if the ABC Ltd able to close at 499, then neither we will earn money nor we lose. So our breakeven point is 499 in this case.
Let's stablish the formula,
Breakeven Point=499
Breakeven point=490+9
Breakeven Price=Strike Price Of long Call + Net premium Paid


let me explain the formula mathematically for better understanding.

Assume ABC Ltd closed at 499 on expiry

Value of 490CE = 9, P/L=-13

Value of 500CE= 0, P/L=+13

_____________________________________________
Our Net Profit /Loss=13-13=0

Now lets understand the second scenario, if ABC Ltd close at 500,
The premium of 490CE will be 10/-, Loss from this options =22-10=12/-
The premium of 500CE will be 00/-, Profit from this options= (13-0)=13/-
___________________________________________________________________________
Net profit =13-12=1/-, if ABC Ltd move up unlimited above 500, then also no change will be there in profit.


Maximum profit: As I mentioned earlier that maximum profit could be less than your risk, here we will see that. Here our maximum profit=1/-

Maximum profit = 1

                                  = 10 - 9
                              = (500-490) - 9
                              =Strike Difference - Net premium Paid
We have Established the formula of maximum profit for Debit Call Spread as below,
Maximum Profit = Strike Difference - Net Premium Paid

So you can see, in this strategy maximum profit possibility is only 1/- where maximum loss is 9/-


Why this outcome?

This outcome occur because of strike selection, if we choose two consecutive strike price options, one for buying and another for selling, then always this outcome we will see. 

Which mean if we can keep a good gap between two strike price then only the possibility of maximum profit will be greater than maximum loss. Keep this thing in mind while selecting strike price for bull call spread. 

Adjustment Or Managing The Position:
There are many ways we can adjust our position if we feel our view is incorrect. Bull Call Spread is created when we have bullish view on the underlying. But the market scenario can be changed anytime.

Assume suddenly we feel underlying price will become choppy, in that case will lose money, now to protect we can convert our position into a Long Call Butterfly Strategy. Now we will sell another Call options what we have already shorted, and will buy another higher strike price call options.
In this case situation will be like below...
Long 490CE 1 lot (Already we have)
Short 500CE 2 lots (We have 1 lot short already and fresh 1 lot to be shorted)
Long 510CE 1 lot (New one we have to add)
If the market remain range bound, we will able to make money, or at least able to minimize risk.

Secondly we feel potential downside risk of the underlying, in that case we can add put options with the strategy and minimize our risk, this is known as Debit Call Spread with a Protective Put Options.

Bear Put Spread or Debit Put Spread

Bear put spread or debit put spread is a bearish options trading strategy with two legs put options where we long a put options with higher premium and at the same time we short a put options with lower premium of the same underlying, expiry date and same quantity.
When the traders believe that the underlying will fall faster but due to higher volatility or more time remaining to expiry, buying only put options is risky, that time to minimize the time value decay risk or to save from large losses due to any unforseen possibility of sudden reversal in direction, traders go for Debit Put Spread.
Buy Put Options With Higher Premium
Short Put Options With Lower Premium
Same underlying, same expiry and same quantity.

debit_put_spread_or_bear_put_spread

Breakeven Point = Strike Price Of Long Put Options - Net Premium Paid
Maximum Loss = Net premium Paid
Maximum Profit = Strike Price Difference Between Traded Options - Net Premium Paid

Technical Scenario:
Price is in down trend and approaching a higher time frame supply and then giving any selling confirmation in lower timeframe chart or underlying is in down trend and and currently in corrective movement, and creating any price action candlestick pattern like dark cloud cover, eveningstar, evening doji star, short CMO, trendline breakdown or shooting star etc. are the perfect technical scenario for bear put spread. Remember, even in options trading technical analysis is more important than options greeks or open interest etc. if you misjudge the trend you will pay the price.

Volatility:
As it is a directional trade therefore more volatility is preferred.

Strike Selection:
Like debit call spread you can select different combination as per your risk tolerance, experience and expiry time remaning. The more difference between two strike selection, the more risk you have to afford, it is also true that if the strike price gap is bigger then profit potential is also bigger in case price follow your direction. 

Until you are a seasoned trader, practicing with 2 strike gap is preffered. For example NIFTY strike difference is 50 points, so if you buy 24000PE then selling 23900PE is preffered.

Example:
Assume Nifty spot trading at 24100 and we are bearish in the market.
Long 24200PE @ 150
Short 24100PE @ 100
------------------------------------
Net premium paid = 50
Now If Nifty fall then premium of 24200PE will rise and we will make money from it at the same time the premium of 24100PE will also rise and we will lose money from it, but as the 24200PE is ITM options, due to higher Delta, premium of this strike price will rise faster than 24100PE, so we will make more money than we lose.

Lets calculate the probable outcomes. What will happen If Nifty close at 24200 on expiry?
Premium of the Nifty 24200PE will be 00, lose from this options=150/-
Premium of the Nifty 24100PE will be 00, profit from this options=100/-
_______________________________________________________________________________
Net loss from this strategy =50/-, now if we dont want to lose money we must earn money from long put, on expiry if we able to atribute 50/- intrinsic value from the long put options (24200PE) neither we will lose money nor we gain.
Already we know the Intrinsic Value of A Put Options = Strike Price - Current Market Price.
In this case, if we get back 50/- as intrinsic value from long put options then neither we will lose money nor we gain, so we can say ..
50=24200-X, where X= current market price which is our breakeven point
X=24200-50
Breakeven = 24200-50
Breakeven= Strike Price Of Long Put -Net Premium Paid

Now let us learn how to calculate Maximum profit.
As it is a debit put spread, we will earn money if the underlying goes down. lets assume the Nifty close at the lower strike price 24100 on expiry.
Premium of 24200PE will be 100, loss from this options =150-100=50/-
Premium of 24100PE will be 00, Profit from this options=100-0=100/-
_______________________________________________________________________________
Net Profit=100-50=50/-, now notice one thing, if Nifty goes below 24100, then 24200PE will give us profit while 24100PE will give us loss equally, so profit potential won't change thereafter. So we can say maximum profit is possible in Debit Put Spread if the underlying close at or below the sold put options strike price.
Here maximum profit =50
maximum Profit =100-50
Maximum profit = Strike Difference Between Two Traded Options - Premium paid
                              
If NIFTY rise and expire at or above 24200 then both the put options premium will become zero, and will lose the premium paid 
So our Maximum Loss = Premium Paid =50/-

Adjustment Or Managing The Debit Put Spread Position:
Like Debit call spread, we can adjust our position for Debit Put Spread in many ways if suddenly there are any changes in market view or direction. Normally we go for Debit put spread, when our outlook is bearish. If the market volatility and or direction changed suddenly we will lose money. That time either we can close our position with a loss or can try to adjust the position. 
If our vew changed as neutral from bearish then we can convert Debit Put Spread into a Long Put Butterfly Options Strategy, by selling one more lot ATM put options and buying 1 lot OTM put options. 

Or if our view changed to bullish from bearish, then either we can long call options along with the Debit Put Spread, it will be consider then as Debit Put Spread with a Protective Call Options Strategy. 

Thus, we can close our position with a profit or at least able to minimize our losses.

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Know About Options Termilogy & Other Options Strategies:

Options Terminology
Long, Short & Protective Call
Long, Short & Protective Put
Butterfly Spread
Credit Spread
Straddle
Strangle
Iron Condor

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