Debit spreads are trades where options traders invest a net debit up front and then look to close the trade for a credit larger than the original debit. Bull-Call Debit Spreads use call options to create a position with an initial debit and bullish slant. The up-front cost is the most that will ever be at risk with this kind of trade, while the target profit is the difference between the bought and sold strikes minus the initial debit.
To create a bull-call debit spread, purchase a call at one strike price and sell another call on the same stock and with the same expiration date at a higher price. The sold call will be less expensive, so it will offset some of the price of the bought call, leaving a net debit on the trade. Typically both of these options will be in-the-money at the trade’s inception.
As long as the stock is above both strike prices at expiration, the investor will realize his maximum profit on a bull-call debit spread automatically when both calls are automatically exercised and assigned. He will buy the stock for the strike price of the lower call, then turn around and sell the same stock for the strike price of the higher call, creating a credit equal to the difference between strikes and achieving the target profit.
In the worst case, the stock reaches expiration below both calls strike prices. In this case, both options will expire worthless and the investor will lose hos or her entire initial investment.
If the stock reaches expiration between the strike prices of the two calls, the bought call will automatically exercise, but the sold call expires worthless. This results in a long stock position that will cost a large amount of cash and unless that cash is available, to clean up the trade it will need to be sold at current market prices. Market price will be more than we pay by exercising the bought call, but probably not enough to also make up for the initial debit.
Our analysts will usually exit trades that might be in trouble before expiration passes and make the decision for us. To exit a bull-call spread, buy back the sold call and sell the bought call for a net credit.
InvestorsObserver analysts usually look for bull-call debit spread trades that have sold calls 10% or more in-the-money, so that our positions make a profit if the underlying stock rises, stays flat or even drops by a little. Trades with this amount of protection often target returns of 5-10% in just two months for annualized returns (for comparison purposes only) of 30-60%.
You can find Bull-Call Debit Spreads in the Vertical Spreads Portfolio.
A similar type of trade with a bearish bias is known as a bear-put debit spread.