What is a Debit Spread?

Malcolm Tatum
Malcolm Tatum

The debit spread is one form of an option spread. Within the context of this type of spread, the option that is purchased is of greater value than the premium of the option that is sold. Because of the difference between the purchase and sale, the cash balance or value of the trader account is decreased, resulting in a debit. The hope is that while a debit applies in the short term, the value of the option that is purchased will soon exceed that of the option that was sold and result in a profit from the venture.

Debit spreads might use calls during bullish markets or puts during bear markets.
Debit spreads might use calls during bullish markets or puts during bear markets.

Sometimes referred to as a net debit spread, the use of this type of spread takes place in just about any type of market environment. When a market is currently exhibiting a bullish posture in general or with a particular stock option, the investor may engage in a debit spread that is based on the use of calls. Should the stock or the general market currently be undergoing a bearish phase, the debit spread may involve the use of puts. A mixture of puts and calls may also be appropriate ways of employing this type of spread as well.

In any environment, the result of utilizing a debit spread is a short-term decrease in the cash balance of the trader account. Choosing to make use of this type of strategy does carry a degree of risk. In the event that the acquired security does not begin to appreciate in value and eventually yield a return higher than the security that was sold, the spread will remain and the difference in the cash balance is not recovered. Thus, the strategy relies not only on the price of option elements, but also on the spread option position that exists between the option purchased and the option sold.

However, investors normally decide what to sell and what to buy very carefully. This means research is conducted to determine the most likely projected course of activity for the option that is purchased versus the option that is intended for sale. When the option that is acquired appreciates in value while the option sold continues to depreciate in value, is can be said that the debit spread between the two continues to widen, with the widening gap of the spread option being to the advantage of the savvy investor.

As with any investment strategy, the success of a debit spread rests on choosing the right options to buy and sell. Should the option that is sold suddenly make a dramatic comeback while the acquired option languishes, the investor essentially takes a hit as a result of the transaction. But if the purchased option appreciates dramatically while the option sold languishes or decreases in value, the investor receives a great deal of benefit from the transaction.

Malcolm Tatum
Malcolm Tatum

After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.

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