What it means
Options are contracts that give the right, but not the obligation, to buy or sell an asset at a fixed price (the strike price) before a certain date. A single option can be expensive and can lose all of its value.
A debit spread lowers the cost by selling a second option, which brings in some cash to offset the price of the first. The two legs are on the same asset and expiry but at different strike prices.
In a bull call spread, you buy a call at a lower strike and sell a call at a higher strike, hoping the price rises. In a bear put spread, you buy a put at a higher strike and sell a put at a lower strike, hoping the price falls.
The trade-off is clear. You give up unlimited profit in exchange for a lower cost, so the best outcome is the gap between the strikes minus what you paid.
The worst outcome is losing the net debit, which is known from the start, and that certainty is the main attraction. Companies and investors use debit spreads to take a view on price with limited risk, or to hedge.
A business exposed to a rising commodity price might use a call spread to protect against a moderate rise without paying the full price of an unlimited call. The cost saving matters when margins are thin.
Timing and volatility also matter. The value of the spread changes as the expiry date approaches and as the asset price moves, and the position generally earns its maximum profit only at or after expiry if the price finishes beyond the higher strike.
Closing early usually produces a result somewhere between the two extremes. Debit spreads are contrasted with credit spreads, where you receive cash upfront and risk a larger loss.
Choosing between them depends on how confident you are in the direction and how much cash you want to commit.
In practice
Real-world examples.
Example
An investor expects a technology share to rise moderately after earnings. She buys a bull call spread, paying $2.50 per share and capping both her risk and her reward.
Example
A food manufacturer worries that wheat prices may jump in the next three months. It buys a call spread on wheat futures, which costs less than a straight call and covers the likely range of price rises.
Example
A portfolio manager thinks an index will drift lower but not crash. He uses a bear put spread to profit from a fall of up to 8% while paying a smaller premium.
Formula
Calculation
Formula (bull call spread): Net debit = Premium paid - Premium received. Maximum profit = (Higher strike - Lower strike) - Net debit. Maximum loss = Net debit. Break-even = Lower strike + Net debit. Multiply by 100 for a standard contract covering 100 shares.
Worked example: a trader buys a $50 call for $4.00 and sells a $55 call for $1.50 on the same share and expiry.
Net debit = $4.00 - $1.50 = $2.50 per share, or $250 per contract
Maximum profit = ($55 - $50) - $2.50 = $2.50 per share, or $250 per contract
Maximum loss = $2.50 per share, or $250 per contract
Break-even = $50 + $2.50 = $52.50
If the share ends at $56 the trader earns $250, and if it ends below $50 the trader loses $250.Case study
Seen in the real world.
Valleyfield Mills is a fictional flour producer used here for illustration. Its treasurer feared that grain prices would rise by 10% to 15% over the next quarter, but buying a full call option looked too expensive. She instead bought a call spread with strikes at $6.00 and $6.90 per bushel, paying a net debit of $0.35 per bushel.
Prices rose to $6.60, so the spread paid out $0.60 per bushel, a gain of $0.25 after the debit. The company's purchase costs rose, but the gain on the spread softened the blow without a large upfront payment.
In this illustrative story the treasurer accepted that she would not be protected against a price above $6.90. She judged that outcome unlikely and was comfortable with the limit.
Watch out
Common mistakes.
- Treating the debit as a fee. It is the maximum loss, and you lose all of it if the price finishes on the wrong side of the lower strike.
- Forgetting the profit cap. The gain stops at the higher strike, even if the price keeps rising.
- Ignoring the expiry date. Time passing changes the value of the spread and can erode it if the price does not move in time.
Questions
People also ask.
What is the difference between a debit spread and a credit spread?
A debit spread costs money upfront with limited risk and limited reward. A credit spread pays you upfront but carries a larger possible loss than the credit received.
When does a debit spread make sense?
When you expect a moderate move in one direction and want to limit cost and risk. It is less suitable if you expect a very large move.
Can I lose more than the debit?
No, with a properly constructed spread the most you can lose is the net debit. Brokers may require approval levels before allowing options trading.
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