What are debit spreads?

Understanding Options Trading

Episode 07 – Debit Spreads

David McGann (00:17):

Hello to all of our viewers. My name is David McGann. I'm a director here at BMO InvestorLine. I'm thrilled to be co-hosting today's webinar on multi-leg strategies and specifically zooming in on debit spreads. This comes to you as part of our webinar series that seeks to unpack options trading. Be sure to check out our education hub to find other webinars in the series that may be of interest to you as well.

(00:39):

Once again, today we'll be joined with our friends at OptionsPlay. I'm pleased to introduce Tony Zhang. Tony is chief strategist at OptionsPlay, where he leads development of options trading products, education for investors, and oversees the firm's quantitative options research. He is a frequent contributor to CNBC for analysis on the markets with a specific lens using technical analysis, fundamentals, and options.

(01:02):

We're pleased to have Tony back and I know we have some great content to review today on debit spreads. With that, Tony, I'll hand things over to you.

Tony Zhang (01:10):

Thank you so much, David, and thank you so much everyone for joining us. Today we're going to be building on our Foundational Options Education Series where you learned about single-leg options, long calls, long puts, short calls, short puts. We're going to talk about how to combine those into the next stage of your options education journey, into multi-leg strategies. Specifically today, we're going to cover debit spreads, debit vertical spreads, what they are and how they can potentially benefit for your options trading.

(01:43):

Now before we get started, what we are going to discuss here today is purely for education and demonstration purposes. It is not a solicitation or recommendation to buy or sell any of the specific securities that we'll be using as example purposes during today's session.

(01:59):

Let's take a look at what we're going to cover during today's session. We'll start off by just introducing what is a debit vertical spread. For those of you that may not be familiar with this specific strategy, we'll make sure you understand how to construct it and go through some examples.

(02:14):

We'll start off with a bull call spread. That is a debit vertical spread that you can utilize in a bullish view of a specific security. Then we'll cover a bear put spread. We're going to probably spend a little bit more time on the bull call spread just to make sure you understand the strategy, the foundational elements of how they're built and specific outcomes because the bear put spread is effectively a mirror image of the bull call spread simply for bear strategies. Then what we'll do is we'll do a review of trading debit spreads at the very end to help you summarize everything that you've learned during today's session.

(02:52):

But the primary thing that I want you to be able to walk away from today's session is a clear understanding as to how can you gain a directional exposure in the markets utilizing options while minimizing your risks using strategies such as a debit vertical spread.

(03:08):

Let's go ahead and get started. Let's talk a little bit about what a debit spread is. Now, before we define a debit spread and talk a little bit about how they're constructed, I want to take a step back and make sure you understand when you might want to consider utilizing a strategy like a debit spread. First and foremost, you have to understand that these strategies are for speculative trading. Meaning this is a strategy that you would deploy when you have a directional view on the market, specifically a directional view where you believe that a specific security is trending either higher or lower and you believe that that trend will likely continue or reverse. The idea is that you have a directional view and you're trying to take advantage of that directional view by attempting to profit from it based on that directional view using a option strategy such as a debit spread.

(04:03):

Now, a debit spread also I think is important to understand because for a lot of traders that are exploring different options strategies, different option strategies have different characteristics. One of the most important ones about debit vertical spreads that I think is important for trading for most investors is the fact that it has defined risk. Not only does it have limited risk, it also has limited potential reward. What that means is that before you get into a trade, you know exactly how much you can potentially lose or gain before you get into that trade. Based on the number of contracts that you trade, you know exactly what your max loss and max gain is going to be on that specific trade if you were to hold that trade through expiration.

(04:51):

Lastly, I think it's really important for investors to learn about these types of multi-leg strategies such as debit spreads because if you are using only single-like option strategies such as long calls, long puts, or even short calls and short puts, what we're trying to do here with these multi-leg strategies is to improve your odds of success, improve your probability of profit on these types of strategies.

(05:17):

The best way to really understand that is when we do a comparison between a single-like strategy and a multi-leg strategy. After we go through an example of how to construct these strategies, we will go through a scenario analysis to see if the stock goes higher, if it goes lower, where do you outperform between the single-like strategy versus the multi-leg strategy and show you how you improve your odds of success when you use multi-leg strategies such as a debit vertical spread.

(05:48):

Now, it's really important to remember that when you're trading these types of speculative strategies using a debit vertical spread that you need to trade them in a market where you believe that there's going to be a fairly significant directional move in one direction or another in order for it to make sense to utilize this type of strategy. Meaning if let's say you believe that a stock is not going to make a material move either higher or lower, this might not be the right strategy for that specific outlook. We will talk about other strategies in future classes that might be better suited when you have more of a neutral view on an underlying security. But when you have a directional view, that's when you want to deploy a strategy such as a debit spread.

(06:34):

Before we break down a debit spread specifically, let's actually take a look at what we call the strategy driver of a debit spread. What that means is that even though you're trading multi-leg strategies where you're consisting of more than just a single leg of the options strategy, there's always typically one leg that is the main driver of that strategy. When we're talking about a debit spread, that main driver for a bullish strategy is going to be the long call. For a bearish strategy, it's going to be a long put.

(07:04):

The first example we're going to look at here is a bullish strategy. We're going to look at a long call. We're going to use Apple as an example. Let's say we buy an Apple call option that has a strike of $200. We pay in this instance $10 for this call option. Now what that means is that when you buy a call option, your view on the underlying stock is you believe that this stock is going to increase in value in the future. That's why you buy a call option because you believe that it's going to increase in value in future. You're hoping that it's going to exceed the break-even price of your call option that you've purchased in order to turn a profit on your investment.

(07:47):

The trade here when you have a bullish view and you are using a single like strategy is to simply buy let's say an at-the-money call option. Let's say Apple's trading at $200. You buy the $200 call option. In this particular instance, you pay $10 for that call option.

(08:05):

When you buy a single-leg option like a call option, one of the characteristics of this strategy that I think attracts a lot of beginner investors to this strategy is the fact that the potential reward on a long call option is unlimited. Meaning if the stock continues to move higher and higher and higher, you will continue to make more and more profits. Meaning there's no limit as to how much you can potentially make on the specific trade if the trade goes in the direction you expect it to.

(08:36):

On the downside, if the trade doesn't go in the direction you expect it to, and let's say the stock were to drop significantly after you buy a call option, well, not only do you have the unlimited upside potential, but you have limited risk. Meaning if let's say Apple was, in a very unlikely event, drop 50% or even more than that between now and the expiration of your options contract that you've purchased, the risk that you have on the specific trade is limited to how much you pay for that option.

(09:12):

In this particular case, because you'd paid $10 for the call option, which is roughly 5% of the stock's value, that's all you risk in this particular instance. You have unlimited upside potential if you get the directional view correct. If you get the directional view wrong, you're risking in this particular case $10 per share or roughly 5% of the stock's value. That asymmetrical risk profile is what attracts a lot of investors to utilizing options. Why not have unlimited upside while you can reduce your overall risk to the downside.

(09:46):

But there is one trade-off with this asymmetrical risk profile. That's the fact that you pay $10 for this call option and you have to exceed the break-even price of that strategy before you turn a profit. What that means is that in this particular case, if you're paying $10 for a $200 call option, the break-even price on the stock is on the strategy is $210. You have to exceed $210 by expiration in order for you to turn a profit.

(10:17):

What that means is that you could potentially buy a call option, have the directional view on Apple be correct, but still actually lose money on the trade because if let's say the stock ends up at 205 by expiration, because it hasn't exceeded your break-even price of $210, even though you got the directional view right, you actually still lose money on the trade. You have to not only believe the stock is going to move higher, you have to believe the stock is going to move materially laterally above the break-even price of the call option in order to justify buying that call option. Not every day are you going to come across a stock that you have a bullish view on that you also believe that the stock is going to make a fairly significant rally between now and the expiration date to justify buying the call option. That is where the debit spread comes into play.

(11:10):

Let's take a look at a call debit spread on the same example. I have a bullish view on Apple, currently trading around $200. Let's say I go out and buy the $200 call option on Apple, and just like the previous example, I'm paying $10 for that call option. Now think about an option because options have an expiration date, meaning there's a time limit as to how much time you will have to gain exposure to that underlying stock. What that also means is that within that time span, there's generally a reasonable amount as far as how far you think the stock could potentially move in the direction that you expected it to move in.

(11:54):

In this particular case, what you can do is instead of just outright paying on a call option which gives you unlimited upside exposure, what you can actually do is you can actually sell some of the upside in exchange for some premium.

(12:08):

In this example, instead of just outright buying the $200 call option and receiving unlimited upside potential, what I'm going to do is I'm going to at the same time sell an Apple 220 call option. In this particular case, let's say I collect $3 to sell that Apple $220 call option. What you're trying to do here is find a balance between a strike price such as 220 where you believe that the stock is not likely going to move materially much higher above 220, and at the same time it's going to collect a little bit of premium that's going to offset the overall risk on the trade. Because if you use a debit vertical spread, such as the example we're using here, instead of paying $10 for the upside exposure in Apple, now you're only paying a net debit of $7 for this bullish exposure here in Apple.

(13:03):

What you're doing here is you're basically reducing your overall risk to get into the trade. You're down to just $7 for the strategy. You're also reducing the capital outlay required to get into the trade. Instead of paying $10 per share to get into the trade, you're only paying $7 per share. That has the added benefit of not only reducing your risk, but if you do get the directional view correct, it's actually going to increase your return percentage because you're laying out less capital to get into the trade.

(13:37):

You would basically trade this type of strategy when you have the exact same view as in the previous example when you have a bullish view in the stock, but what you want to do is you want to choose a strike price where you believe that the stock is not likely going to go materially higher above that strike price so that what you're doing is you're selling a call option against the call option that you're buying. That's going to collect some premium, reduce your overall risk, potentially increase your return on the trade if you do get the directional view correct in exchange for trading off the upside above that short strike.

(14:14):

In this particular example, if the stock were to move materially above 220, I'm not going to be able to participate in that upside above the upper strike of my call option because I've effectively sold away any additional exposure above 220 in exchange for $3 of premium right now. That $3 premium is effectively a 30% reduction in your overall risk. You're going to see in the next slide, as we go through some examples of when the stock does move higher or lower, how much 30% savings in risk and capital outlay actually translates to in the overall trade at the very end.

David McGann (14:57):

Thanks, Tony. That was a great summary. If I were to try to just paraphrase I think some of what you shared, basically what we're doing by adding the short leg by selling the 220 call is we're offsetting some of the cost, reducing a bit of the risk, but we're giving up some of the potential top end, I guess, value that we could get. There's a cap to this strategy. Is that right?

Tony Zhang (15:22):

Yeah, that's exactly right. When we just buy the call option, we have unlimited upside exposure. If the stock goes to 230, 250, 300, we'll keep gaining exposure, and we'll keep increasing our profits as the higher the stock goes. When you trade a vertical spread like this, we are effectively capping our upside above 220. Even if the stock exceeds 220, we will not participate in any further upside because we've collected $3 to start off with selling that 220 strike. That's correct, David.

(15:54):

With that, let's now move into taking a look at how these two strategies perform side by side given the outlook that we have. In this particular example, just like the two that we went over before, Apple's trading at $200, and I have a bullish outlook on the stock. What we're going to do here is we're going to compare the two strategies that we just laid out, outright buying the $200 call option for $10 versus buying the 200, 220 debit call spread or bull call spread for a net debit of only $7. Reducing our overall risk by $3. Let's see how that compares side by side for different outcomes.

(16:35):

What we're going to look at are three different outcomes for this trade. Obviously after you buy a call option and you believe the stock is going to move higher, three things can happen, the stock can move lower, the stock can stay where it is or the stock can move higher. Let's take a look at the three different examples and how they would perform based on the two different strategies and see side by side what differences you're going to have and where you might be better or worse off between the two different strategies.

(17:06):

Let's say in the first example the stock doesn't move or the stock moves lower. Now whenever you buy a call option or you use a debit spread structure like this, whether the stock stays where you are or moves lower, especially with at-the-money call option, the outcome is the same, right? In this particular case, if the stock stays at 200 or the stock were to decline, you effectively lose the investment that you have or the investment that you've made on both of these strategies.

(17:35):

Now in the call option example, I've paid $10 per share or $1,000 per contract because each contract represents 100 shares. If I buy a call option for $10 and the stock stays at $200 or moves lower, I effectively lose all $1,000 that I've paid for that call option. If you look at the debit spread, I also lose the entire premium or the investment that I've made in that debit spread. But because I've collected $3 for selling that 220 call option, instead of just losing $1,000, I actually gained $300 on that short call option that also expires worthless in this particular example. My net loss on the specific trade is only $700 versus the $1,000 dollars. That's the first scenario where based on the debit spread, you're going to come out ahead versus just outright buying that call option. You're reducing your risk, so if the trade doesn't work out, you're reducing your overall capital outlay.

(18:37):

Now in our second example, let's say the stock does move in the direction we expect it to. It doesn't move perhaps as far as we would like, but it does start to move in the direction that we expect it to. In this particular example, let's say the stock moves up to 210 in the time between now and the expiration date of the option. Now if the stock reaches 210 by expiration, if I just bought a call option for $10, my break-even price on this trade is $210. $10 plus the $200 strike price is $210. If the stock lands at $210 at expiration, I end up with a break-even on my long call, meaning I don't make money, but I also don't lose any money. I spent $1,000, I basically make back my $1,000 and I'm at break-even. Not a win, not a loss if you simply bought a call option.

(19:31):

Now if you had bought a debit spread, this is really where you'd start to see a small gain because I only paid $7 to gain that upside exposure in Apple, which means my break-even price on this specific trade on the debit spread is only $207. If the stock rallies to $210, here I'm going to turn a small profit of $300 per contract for my trade. If I laid out $700 for my trade and I've now made $300 in profits, that is nearly 40% profit on this specific trade. Even though the trade moved just marginally higher above my break-even price, I do still have a positive return on my trade to show for it. This all comes down to that 30% reduction in capital outlay and capital risk that's going to turn a trade that was a break-even trade into a profitable trade by switching from a single leg to using a multi-leg like a debit vertical spread.

(20:34):

Now let's look at this last scenario. Let's say the stock really takes off. Maybe earnings comes out and we have better than expected earnings or some good news comes out with regards to the product with AI, whatever that catalyst is, the stock exceeds our expected move. Now let's say the stock ends up at $230 at expiration. Well, this is really where the call option really shines because you get unlimited upside exposure.

(21:02):

In this particular example, if the stock ends up at $230, that's a profit of $20 per share or $2,000 per contract. I spent $1,000 on my trade. I've now gained $2,000 in profits. That's a 200% return on my investment using that long call. I will say those types of examples don't happen very often, but when they do, the call option really shines.

(21:28):

Now in our second trade where we use the debit vertical spread, because we sold that 220 strike, remember we are capping any potential gains above $220. If the stock lands at $230, we're not participating in that last $10 of that rally of Apple stock. If the stock ends up at 230, yes, we still make $2,000 for the long call portion of our debit vertical spread, but what we're going to do is we're going to lose $700 per contract to the short call option of our vertical spread, which means that we net here, in this particular case, a profit of $1,300.

(22:10):

Now keep in mind here, now we spent about $700 on the debit vertical spread. Here we're turning, even in this scenario where we are effectively losing out on some of the potential profits because the stock exceeded that 220 strike, we still net out a $1,300 gain, profit on the specific trade. If you look at the return of these two strategies, they're actually still quite similar even though it looks like on paper you're making less profits on that debit vertical spread.

David McGann (22:43):

Tony, look, I think this is an excellent way to showcase the two strategies side by side, if you will, and obviously consider different outcomes at expiration. I think you hit a bang on. Even though for the bull call spread, the profit in the expires at 230 scenario is 1,300, that's still nearly doubling your money because your upfront capital outlay, your initial debit is $700, so nearly a double, much like you achieved with just a long call turning a thousand into 2,000. Nice win there, right? You're almost performing the same there. It expires at 210. You actually bag a bit of a profit, $300 versus breaking even on the long call. Then, of course, if the trade goes against you, you're not losing as much because you receive that credit.

(23:37):

What really jumps out at me, and I think probably jumps out a lot of our audience members, especially those that are newer to debit spreads and these strategies, is it really looks like a compelling strategy where you win across the board. Like we said earlier, obviously if Apple went to 240, 250 and above, you're not participating there, but I think you even mentioned it, those are probably more the rare and outlier type circumstances. This is a strategy that seems to be super compelling. It almost jumps out at you to say, "I might often be better off going down the route of a debit spread versus just a straight long call." I'm curious, what insights do you have to offer on that?

Tony Zhang (24:24):

Yeah, absolutely right. That's exactly why we laid it out in this particular table because a lot of times when you just look at the dollar amounts, it might seem like the long call far exceeds in that last example where you might want to use that long call because of that, even in the rare case you're going to make substantially more profits. But as you pointed out, even though it looks like on paper it's a much higher dollar amount, but on a percentage basis it's actually very, very similar.

(24:54):

In out of the three scenarios, in the last scenario where it looks like the long call actually outperforms, you're actually performing very similar return profiles. But in the other two scenarios where the trade doesn't work out exactly the way you expect it to, you're actually outperforming the long call, which is why out of the three different scenarios, I would say on average you're going to perform better using the debit vertical spread, which is why we advocate for investors to at the very least learn these types of strategies, understand that these are strategies that you can use in your portfolio. You might not use them every single time, but you might find them useful more often than not.

David McGann (25:32):

Excellent, thank you.

Tony Zhang (25:34):

Lastly, let's talk a little bit about when to use these specific strategies. Like we mentioned earlier, debit spreads are for when you have a directional move. In this particular case, when we look at a chart here, the idea of using a debit vertical spread is when you believe the stock is going to rally perhaps from a previous support level to the next resistance level, and you believe that there's a directional move that's going to happen.

(26:01):

It also is also a strategy that is better used when there's a lower implied volatility environment, simply because the strategy driver of the strategy is a long call. Long call options will perform better when implied volatilities are low, meaning the options are cheaper and the premium that you have to pay for that call option is a little less, which also means the break-even price of your strategy is going to be a little closer to the current price of the underlying stock.

(26:30):

But generally speaking, if you've established a bullish trend and you've waited for a pullback here in the bullish trend, you're expecting that trend now to continue, those are examples of when you might want to consider using a debit spread. Where you have defined support, defined resistance, and you simply use the debit spread to straddle that defined support and resistance level to trade within that trading range. You have the choice of either using a long call or a debit spread in these types of examples, but like in the scenario that we showed you, many times you might find that the debit spread will give you a better risk-reward ratio majority of the time when you use these types of directional views in the overall markets.

David McGann (27:15):

Tony, I want to build on that for a minute, if you don't mind. Under that used for section, we introduced the idea of implied volatility, and in particular we call out directional move with lower implied volatility. It means options are likely cheaper to buy. What about the opposite situation or scenario where implied volatility is higher? Does that negate or take away from the strategy? Can you expand on that a little bit?

Tony Zhang (27:45):

Really fantastic question. It's actually, even though it is ideal to use debit spreads in a low implied volatility environment, I would say that when implied volatility is high, that is even more of a reason to consider using a debit vertical spread. Because when options are very expensive, what that means is that just simply outright buying a call option is going to be expensive, which means that the premium that you pay is going to be higher and the break-even cost is actually going to be further away from the current price of the stock, which is more of a reason to sell that upper strike, collect some premium and reduce the overall risk, reduce the overall capital outlay and reduce the break-even price on the strategy. The higher the IV, the more I think that it makes sense to use a spread to reduce a little bit of that in high implied volatility, the expensiveness of just outright buying that straight call or put. Hopefully, that-

David McGann (28:46):

Interesting. Basically, it works really well in low implied volatility environments, but potentially could even work better in higher implied volatility environments because, of course, you're getting that higher premium on the short leg that you're selling. Really insightful stuff, Tony. Thank you for expanding on that.

Tony Zhang (29:04):

I would just clarify to say I think it's even more necessary to use it in high implied volatility environments than low implied volatility environments because in low and volatility environments I would say you have a better choice. You can choose between the call option and the debit spread. Versus in high implied volatility environments, I would say it almost necessitates, to some degree, using that spread to negate the fact that implied volatility or options are so expensive.

(29:32):

Now that we've spent quite a bit of time dissecting a bull call spread, a debit vertical spread for a bullish view, let's take a look at it for a bearish view. This is really where if you understood everything that we laid out in the first example, this is really just going to be a mirror image of what we learned before. Let's take a look at, let's say I have a bearish view here on Apple. Apple's trading around $200 and for whatever reason, I believe that the stock is going to drop in value going forward.

(30:02):

This is really where as an equity investor, if you were just outright trading stocks, you don't have a lot of choices here. You can either sell your stock and hope that you can buy it back later at a lower price, but as a stock investor, you don't have a lot of choices. You can also sell short, which is not also something that a lot of investors may have access to, but this is really where options can give you bearish exposure to an underlying security such as using a put option contract.

(30:30):

In this particular example, let's say I buy an Apple $200 put option, which is the at-the-money put. Let's say I have to pay $10 for that $200 at-the-money put option. Just like the previous example, what I pay is going to be my total risk on this specific trade, so $10 per share or $1,000 a contract.