How to Trade Vertical Spreads: Putting Debit Spreads

A Debit Spread is an options strategy that involves buying and selling 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 buy is just a bearish bet on a falling stock. To reduce the amount you pay for this put option, you go for a cheaper option with the same expiration date and sell that option. This will turn your put option into a debit spread and give you a defined risk-reward ratio.

What is a put debit spread? What is a vertical put spread?

A sell spread is a bearish options trade with a defined maximum profit and loss. It is constructed by buying a put and selling a lower exercise put against it within the same expiration date. The bought put will cost more than the lower exercise put you are selling, which means you are paying a net debit to open this trade, hence the name.

Sell ​​debit spreads are beneficial for speculating on a security’s decline and for hedging purposes. You will probably make money if you buy a put debit spread and the stock goes down. Additionally, put debit spreads have a positive vega, meaning they benefit from an increase in implied volatility.

How to Trade Vertical Out-of-the-Money Sell Spreads

A put option is considered out of the money (OTM) when its strike price is lower than the current share price. Buying OTM put options is a common way for investors to hedge their stock portfolios in the event of a market decline. 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. Far OTM put options are unlikely to benefit the buyer as they are much lower than the stock price. However, far OTM put options are much cheaper to compensate for the low probability of profit. OTM put debit spreads are great to buy if you are bearish on the stock and think it will go down in the near future.

Instead of just buying a single OTM put option, investors can increase their profit probability by trading a put spread spread. To make a single long put sell debit spread, you only need to sell a lower exercise put in the same expiration. A disadvantage of a short put spread compared to a long put is that the maximum profit is no longer unlimited. However, hedging with a put debit spread is cheaper because part of the cost of the long put is funded by selling the lower-strength 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 XYZ stock is trading at $100 per share and you think it will soon fall below $90 per share. The following is an example of a Sell Flow Spread or a Vertical Sell Spread that you can trade.

Buy-to-open 95-strike put @ 1.00

Sell ​​at the open 85-strike put @ 0.50

Total Debit: 0.50 ($50)

In this example, the long put (i.e. the put option you buy) will profit if XYZ stock goes below 95. Since the 95 strike put costs more and is more close to the current share price, it will trump the 85-strike put that was sold (aka the short put). Since the 95-strike long sell outweighs the 85-strike short sell, you will gain more on the 95-strike long sell as XYZ stock declines than you will lose on the 85-strike short sell. You will also profit from the 85 strike short if XYZ stock expires above $85. Therefore, you will make the maximum profit on this trade if the options expire if the XYZ stock price is just above $85 per share.

Schaeffer’s Vertical Options Trader

To learn more about options trading, sign up for our new Vertical Options Trader newsletter! The Schaeffer Vertical Options Trader trades first-month and out-of-the-money vertical spreads (i.e. debit spreads). Verticals are an important strategy that every options trader should have in their arsenal. Out-of-the-money options offer the greatest leveraged gains, and vertical markets are the smart way to play them. Verticals are the ideal strategy for trading options involving the most volatile stocks in the market. Click here for more information!

VOTlogopetit

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.