Definition: A debit spread is an options strategy that seeks to attain maximum profit by capitalizing on the difference between the premium paid for the long component of the spread minus the premium paid for the short component of the spread.
What Does Debit Spread Mean?
What is the definition of debit spread? A debit spread involves two options (calls or puts), one with a lower market price that the option holder sells and one with a higher market price that the option holder buys. The higher the difference (debit spread) between the two market prices at maturity, the greater the gain for the investor.
Both components trade on the same underlying asset and are exercised simultaneously. Debit spreads are ideal for beginner investors because the maximum loss is the premium paid for the contract (risk-defined).
Let’s look at an example.
Example
Bethany holds 100 shares of a technology company that currently trade at $45. She is bearish on the stock because the recent financial results did not meet the analysts’ expectations and the company seems to be facing liquidity problems. So, Bethany decides to buy a bear debit put spread, expecting that the market price will move modestly downward before maturity. She purchases a put option at a strike price of $47, and she sells a put option at a strike price of $40, which both expire in two months. The long put costs $2.25 x 100 = $225 and the short put costs $1.2 x 100 = $120.
The maximum gain that Bethany can realize is if the strike price is equal to or lower than the price of the short puts at maturity. In this case, she will exercise the long put and her gain will be $47 – $45 = $2 – ($225 – 120) = $210. The maximum loss will be if the strike price is equal to or higher than the price of the long puts at maturity. In this case, Bethany loses the difference between the two premiums paid, i.e. $225 – $120 = $105.
Therefore, the maximum gain is realized at expiration at the strike price of the put options sold ($47 or lower), and the maximum loss is realized at expiration at the strike price of the put options bought ($38 or higher).
Summary Definition
Define Debit Spread: A debit spread is an investment strategy that utilizes a long and short option to earn a profit.
