Risk-Free Option Trading Strategy

Under certain circumstances, an option trade can be risk-free if you time it right.

What is a Debit Spread

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, this may sound confusing, but let’s break down the call debit spread in simple terms.

The call option you purchase is just a bullish bet on a stock moving up. To reduce the amount you pay for this call you go to a cheaper option within the same expiration date and sell this option.

Doing this will turn your call option into a debit spread and give you a defined risk to reward.

Example of a Debit Spread

Let’s say stock XYZ is trading at $100 per share. You are bullish on this stock and expect it to increase to $120 per share within one year. Let’s go over how we could use a call debit spread to take advantage of an increase in the share price:

- Buy +1 $100 call for $1.00

- Sell -1 $110 call for -$0.50

- You would pay a net debit of $0.50 for this spread

If we only bought the $100 strike call, we would have to pay the full $1.00.

Since we decided to use a put debit spread, we reduced the cost of this trade by a whole $0.50 allowing us to keep more buying power on hand.

The downside of this is that we have now removed our ability to make an unlimited amount of profit. If stock XYZ continues to $120 per share we will miss out on some profits since we sold the $110 call and limited our profit potential.

Calculating Max Profit and Max Loss of Debit Spreads

Max profit of a debit spread = width of the strikes — debit paid

- Max profit for the above example = $10 — $0.50 = $9.50

Max loss of a debit spread = debit paid

- Max loss for the above example = $0.50

Debit spreads are defined risk trades meaning that you always know your max profit and max loss for each trade.

This is good because it is less risky than trading naked options.

The downside of taking less risk is of course less reward potential. When trading a naked long call option, you have unlimited upside profit potential.

With a debit spread your max profit is capped once the share price reaches the strike that you sold.

When to Use Debit Spreads

Debit spreads are primarily useful for traders with small accounts or to limit downside potential on an options play.

Keep in mind that if you already have a naked long option in your account, you can turn it into a debit spread.

This is especially good if you are already profiting from your current options trade.

For example, let’s say you were long the $100 call in our example and the stock has increased to $110. That call option went from $1.00 to $11.00. Now you can go and sell the $110 call to complete your spread and because the price of the stock is higher this option is now worth $1.00. Let’s break down what would happen if you sold this call now:

- Long +1 $100 call for $1.00 (now worth $11.00)

- Sell -1 $110 call for $1.00

So, your initial debit paid for the first call option was $1.00.

You then sold the $100 strike call later for a credit of $1.00 after the stock rose.

This means that you have turned this long call into a risk-free debit spread.

You paid $1.00 debit and then received $1.00 in credit meaning your cost basis for the spread is $0. The downside of this is that instead of taking your massive profits you have instead locked in a risk-free play.

If the stock were to fall back below $100 per share again you would lose all of your profits at expiration.

You should also keep in mind that this method requires timing the market which is not easy to do.

Final Tips When Trading Debit Spreads

Debit spreads can be a great strategy for the toolbox, especially for those with smaller accounts.

Stocks that have a higher share price can be costly to trade options on, so the use of option debit spreads can allow any account size to trade these stocks.

It can also be helpful to know that you can leg into debit spreads opportunistically to give yourself a better risk to reward than opening the two options at the same time.

If you are already in profit on a long call or put option, you can consider reducing your risk to potentially even $0 by selling an option with a different strike price.