Options: Vertical Debt Spread

By:  The Editors of TradeWins Publishing

One of the most popular option strategies. . .
and for good reasons!

VERTICAL DEBIT SPREAD: A Quick Introduction

The Vertical Debit Spread consists of purchasing an in the money option and selling an out of the money option of the same expiration month. It is a position that requires us to pay a premium-the cost difference between the option we purchase and the option we sell-in exchange for potentially receiving the difference between the two strike prices.

Some of the benefits include:

1. Lower cost
2. Limitation of risk
3. Ability to take advantage of premium disparity.

This allows a trader to commit less of his capital to any one trade. The second, and probably more important, advantage is limitation of risk. While a futures position burdens the trader with unlimited risk, the risk of the Vertical Debit Spread is absolutely limited to the amount paid for the spread plus commissions and transaction fees. This can be more of a substantial benefit than most traders realize. Even though many futures traders feel that they can limit their risks by the use of "stops," what is not taken into account is that many times, they can be "stopped out" because of the risk of taking a large loss in a market that has begun to make a big move against this position only to see the market reverse and move in their favor.

With the Vertical Debit Spread the trader knows that not only is his risk limited, but he is actually hedging some of his losses if the market goes against him with the gains on the options he sold. These factors can be very important, especially to a trader who finds that, although his ability to predict market direction is good, he is emotionally and financially unable to handle the normal market "noise" of corrections, even when the market is trending in his favor. This psychological advantage of knowing that your losses are absolutely limited can make the difference between a winning or losing trade.

The third benefit of this position is being able to take advantage of disparity in option premiums. This means that we are selling an option that was trading at a volatility higher than the option we were purchasing.

The advantage of this position seems so overwhelming that one wonders why anyone would trade the outright futures contract. Still, there are some disadvantages that should be considered by all traders before they initiate this position. First, we are initiating a spread of two positions instead of one, so there is an extra commission for each trade. Second, orders should always be placed at a specific limit price to avoid slippage that can occur with less liquid options. Third, profit on a "Debit Spread" is limited, as opposed to the unlimited profit potential of futures positions; however, these disadvantages can be a small price to pay for the benefits that accrue with this type of position, and could make the difference between a profitable or unprofitable trade.