Debit Spread: Definition, Example, vs. Credit Spread
Key Takeaways
- A call debit spread allows traders to capitalize on rising markets.
- The strategy includes purchasing a long call with a lower exercise price and a short call with a higher exercise price.
- The gains are maximized with this strategy when the cryptocurrency price is at or above the exercise price of the short call at its maturity.
What Is a Debit Call Spread?
Before we go to the depth of the strategy, let’s cover a call debit spread definition. A debit spread, also referred to as call debit spread, is a financial strategy in which an investor concurrently buys and sells call options contracts with different exercise prices and maturity dates. This strategy results in a net debit to the investor's account, meaning the cost of the purchased options exceeds the premium received from the sold options.
Understanding Call Debit Spreads and Bull Call Debit Spreads
You may be wondering if debit call spread is a bullish or bearish strategy. The answer is that it is considered bullish. Call debit spreads are employed when a trader believes that the price of the base cryptocurrency, such as Bitcoin, will increase. The objective is to profit from the anticipated rise in the value of the crypto asset. Hence, another name for this strategy is a bull call debit spread.
How a Debit Spread Works
A debit spread trading strategy is initiated by buying an option contract with a lower exercise price and selling another contract with a higher exercise price, both with different maturity dates. The distinction in the premiums collected and paid results in a net debit, which is the max possible loss for the trader. As the price of the base asset rises, the spread narrows, and the value of the spread increases, allowing the trader to profit from the price surge.
Essentially, option contracts should be of the same type (calls or puts). In this article we will mainly focus on a strategy with calls.
Call Debit Spread Example
In this section we will provide a debit spread example for you to better understand how it works in option trading.
Let's say the current price of Bitcoin is $20,000. A trader believes that the price of Bitcoin will grow in the near future. To capitalize on this anticipated increase, the trader initiates a call debit spread by purchasing a call option with an exercise price of $20,000 (expiring in 30 days) for a premium of $1,200 and selling another call contract with an exercise price of $22,000 (expiring in 60 days) for a premium of $800. The net debit cost in this case is $400 ($1,200 - $800).
Profit Calculations
The maximum profit a trader can achieve using the strategy is the distinction between the exercise prices minus the net debit. In our example, the maximum profit is $2,000 (the distinction between the $22,000 and $20,000 exercise prices) minus the $400 net debit, or $1,600. The maximum loss is limited to the net debit, which in this case would be $400.
Bull Call Debit Spread Goal
As it was mentioned earlier above, bull call debit spread is tailored to capitalize on the price surge in the base cryptocurrency. When employing this approach, an investor acquires a call with a lower exercise price while concurrently selling a call contract with a higher exercise price. As opposed to buying a single call, the strategy is more cost-effective and allows for a greater chance of yielding a more substantial percentage gain.
Market Outlook
The market outlook of the strategy under consideration is moderately bullish. That is why this strategy can be a suitable choice for investors with a following profile:
- Believing that the rise in the price of the base asset will be not be significant
- Looking for limited risk exposure.
How to Set up a Debit Spread
Setting up a debit spread involves the following steps:
- Determine your market outlook and identify the base asset you want to trade.
- Choose the exercise prices and maturity dates for the long and short call options.
- Execute the trade by purchasing the lower exercise price call contract and concurrently selling the higher exercise price call contract.
Payoff Diagram
A payoff diagram for a call debit spread illustrates the potential profit and loss for the strategy at various price levels of the base asset at maturity. The diagram usually shows a horizontal axis representing the price of the base asset and a vertical axis representing the profit or loss.
The payoff diagram for a call debit spread typically displays a hump shape, with the max profit occurring when the price of the base asset is equal to or greater than the higher exercise price.
Entering and Exiting a Debit Spread
Entering a Bull Call Debit Spread
To enter a bull call debit spread, a trader must concurrently purchase a call contract with a lower exercise price and sell a call contract with a higher exercise price. The net debit paid for this trade represents the maximum loss the market pa can incur.
Exiting a Bull Call Debit Spread
Exiting the strategy both the long and short calls concurrently. The trader can choose to exit the trade early if they believe the base asset price has reached its peak or if the options are approaching their maturity dates.
Time Decay Impact
Time decay, also known as Theta, represents the rate at which an option loses value over time. In a call debit spread, the long call contract with a lower exercise price experiences a greater rate of time decay than the short call with a higher exercise price.
This can negatively impact the overall profitability of the spread, especially if the price of the base asset does not rise as anticipated.
Implied Volatility Impact
Implied volatility reflects the market's expectation of future price movement in the base asset. In general, debit call spreads are profitable if implied volatility experiences moderate increases as it can lead to a higher premium.
However, if the implied volatility increases while the price of the base asset remains constant, the spread may not achieve its max potential profit.
Adjusting a Bull Call Debit Spread
If the market conditions change or the trader's outlook on the base asset shifts, the bull call debit spread may require some adjustments. Such adjustments can include rolling the options to various exercise prices or maturity dates, or adding protective options to hedge against potential losses.
Rolling a Bull Call Debit Spread
Rolling a bull call debit spread involves closing the current spread and opening a new one with various exercise prices or maturity dates. Thus, a trader can maintain their bullish position while minimizing the impact of time decay and potentially increasing their max profit potential.
Hedging a Debit Spread
Hedging a debit spread can involve purchasing additional options or other financial instruments to offset potential losses. This can help protect the trader's portfolio from adverse market movements and limit their overall risk exposure.
Risk
The primary risk associated with a call debit spread is the max loss, which is equal to the net debit paid for the spread. This occurs when the price of the base asset does not increase enough to offset the cost of the long call option.
Maximum Gain, Loss, and Break-Even
The maximum gain for a call debit spread is the distinction between the exercise minus the net debit, while the max loss is limited to the net debit.
Break-Even for a Call Debit Spread
The break-even point for a call debit spread is the lower exercise price plus the net debit.
Call Debit Spread Tips
- Consider the time decay factor and its impact on your strategy.
- Monitor the implied volatility and its effect on option premiums.
- Be prepared to adjust your spread or hedge your position if market conditions change.
Sensitivity to Theta (Time) Decay
As time passes, the value of options contracts erodes due to time decay. In a call debit spread, the long call option at the lower exercise price is more susceptible to time decay than the short call at the higher exercise price. Traders should be aware of the potential impact of time decay on their strategy and consider adjusting the spread or exiting the trade if the base asset's price does not move as anticipated.
Closing Debit Spreads
When closing a debit spread, both the long and short call options should be closed concurrently. This can be done by selling the long call option and buying back the short call option. Closing a debit spread allows the trader to lock in profits, mitigate losses, or adjust their market position based on changing market conditions.
Anything I Should Know About Maturity?
As the maturity date of the options contracts in a debit spread nears, the time value of the options decreases, and the intrinsic value becomes the primary driver of the options' worth. If the price of the base asset has not increased sufficiently to offset the net debit, the trader may face a loss. It's essential to monitor the time remaining until maturity and consider closing or adjusting the spread as necessary.
Important Tips on Debit Spreads
- Choose exercise prices and maturity dates that align with your market outlook and risk tolerance.
- Monitor the time decay and implied volatility since they impact your spread.
- Be prepared to close or adjust your spread based on changing market conditions or as maturity approaches.
- Understand the maximum gain, loss, and break-even points of your spread before entering the trade.
Debit Spread vs. Credit Spread
As its name implies, a credit spread results in a net credit. Unlike debit spreads, debit spreads are suitable for the falling markets. Credit spreads involve selling contracts with a higher premium and buying derivative with a lower premium, effectively collecting the distinction as a credit.
Credit call spread is often referred to as a “bear call spread”.
Call Debit Spread Summary
A call debit spread is a moderately bullish trading strategy entailing the simultaneous purchase and sale of call contract with various exercise prices and maturity dates. This strategy allows traders to profit from an increase in the price of the base asset while limiting their risk exposure.
Frequently Asked Questions (FAQs)
Is a Call Debit Spread Bullish?
Yes, a call debit spread is considered a bullish technique. Therefore, it is used when a trader expects the price of the base crypto asset to increase moderately.
When Would You Use a Debit Spread?
A debit spread is used when a trader expects the price of the base asset to move in a specific direction (upward for a call debit spread) and wishes to limit their risk exposure while potentially profiting from the anticipated price movement.
What Is the Max Profit on a Debit Spread?
The max profit of the strategy under review is the distinction between the exercise prices minus the net debit paid for the spread. This profit is realized when the price of the base asset reaches or exceeds the higher exercise price at maturity date.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
