A debit spread is an options strategy that involves the purchase and sale of the same class of options
A debit spread is an options strategy that involves the purchase and sale of the same class of options with the same expiration date but different strike prices. Right now, let’s break down the put debit spread in simple terms. The put option you purchase is just a bearish bet on a stock moving down. To reduce the amount you pay for this put, you go to a cheaper option with the same expiration date and sell this option. Doing this will turn your put option into a debit spread and give you a defined risk-to-reward.
What is a put debit spread? What is a vertical put spread?
A put debit spread is a bearish options trade with a defined max profit and loss. It is constructed by purchasing a put and selling a lower strike put against it within the same expiration date. The purchased put will cost more than the lower strike put you sell, which means you pay a net debit to open this trade, hence the name.
Put debit spreads are beneficial to speculate on a stock moving down and for hedging purposes. You will likely make money if you buy a put debit spread and the stock moves down. Additionally, put debit spreads have positive vega meaning they benefit from an increase in implied volatility.
How to trade out-of-the-money vertical put spreads
A put option is considered out-of-the-money (OTM) when its strike price is below the current stock price. Purchasing OTM put options is a common way for investors to hedge their stock portfolios if the market falls. Buying put options is like buying insurance on your stock holdings.
The lower the strike price of a put, the more out-of-the-money (OTM) the option is. Far OTM puts have a low chance of profiting for the buyer because they are far below the stock price. However, the far OTM puts are much cheaper to compensate for the low probability of profiting. OTM put debit spreads are great to purchase if you are bearish on the stock and believe it will go down in the near future.
Instead of just purchasing a single OTM put option, investors can increase their probability of profit by trading a put debit spread. To make a single long put a put debit spread, you simply sell a lower strike put within the same expiration. A downside of a put debit spread compared to a long put is that the max profit is no longer unlimited. However, hedging with a put debit spread is cheaper since some of the cost of the long put is financed by selling the lower strike put.
A simple example of a vertical put spread
Analyzing an example of a put debit spread can better help you grasp the concept. Let’s say stock XYZ is trading at $100 per share, and you believe it will drop below $90 per share soon. The following is an example of a put debit spread or vertical put spread you can trade.
Buy-to-open 95-strike put @ 1.00
Sell-to-open 85-strike put @ 0.50
Total debit: 0.50 ($50)
In this example, the long put (aka the put option you purchase) will profit if XYZ stock goes below 95. Since the 95-strike put costs more and is closer to the current stock price, it will outweigh the 85-strike put that was sold (aka the short put). Since the 95-strike long put outweighs the 85-strike short put, you will make more on the 95-strike long put as XYZ stock moves down than you will lose on the 85-strike short put. You will also profit on the 85-strike short put if XYZ stock expires at a price above $85. Therefore, you will make the maximum profit on this trade if the options expire if XYZ stock price is right above $85 per share.
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