Debit Spreads: Understanding & Calculating the Risk

A debit spread is a financial transaction where an investor sells and purchases two options involving the same security. The investor purchases the option with a higher price and sells the option with a lower price. Doing the math, you will see this means the investor initially loses money on the transaction. The amount of money lost is officially termed the "debit spread." However, the ultimate goal is to earn money on the move in the long-run.

Debit Spread Example

Consider an investor holding a call option for a security at $10 per share. She sells the shares, and at the same time she purchases another call option for the exact same security trading at $13. Initially, there is a difference of $3 each share. This $3, the debit spread, is the investor's initial loss on the transaction. However, the investor is anticipating the shares will rise even further in the future, meaning she will earn money ultimately by purchasing the option. When this second purchase matures in 30-days, the security is trading at $17 each share. The investor executes the call, and she earns $4 per share on the transaction. Since she lost $3 on the first debit spread, her total profit is $1 per share after all the options have been executed.