What's a call debit spread?

Jim just sent a Trade Alert for a call debit spread. What’s the difference between call debit spreads put credit spreads?

The great majority of Options for Income trades use the put credit spread strategy, yet occasionally Jim Fink recommends a new or rolled trade as a call debit spread instead. How does he decide which strategy to use?

Every time Jim contemplates trading a vertical option spread, he looks at both strategies for the same strike prices. The risks and rewards of the two strategies are similar. The only difference is whether you assume the risk up front and receive the profit later (call debit spread), or receive the profit up front and assume the risk later (put credit spread). Consider that:

• a put credit spread brings in immediate income because the option you sell is more valuable than the option you buy.
• a call debit spread costs money to place because the option you sell is less valuable than the option you buy.

Why would Jim choose a trade that costs money over a trade that generates income? Because sometimes the math works out better that way.

To illustrate, let’s compare the two strategies using these strike prices: $85/$90. To keep this simple, we’re not factoring in commission fees.

• In the case of the put credit spread, market conditions may dictate that we receive $1.60 per share income now, so we risk $3.40 (the $5.00 difference between the put strikes prices minus the $1.60 income already received). If the underlying stock closes below $85 at expiration, both put options would be automatically exercised, with us buying the stock at $90 and selling the stock at $85 for a net cost of $5.00 per share. Subtract out the $1.60 we initially received and our net loss would be $3.40 per share. (Of course, Jim doesn’t expect this to happen and would issue a roll Alert to forestall assignment.) If the underlying stock closes above $90 at expiration, both put options would expire worthless and we’d keep the $1.60 per share free and clear.
•  In the case of the call debit spread, market conditions may dictate that we pay $3.30 up front but stand to profit by $1.70 (the $5.00 difference between the call strike prices minus the $3.30 cost already incurred). If the underlying stock closes below $85 at expiration, both call options would expire worthless and our loss would be limited to our up-front cost of $3.30. If the underlying stock closes above $90 at expiration, both call options would be automatically exercised, with us buying the stock at $85 and selling the stock at $90. Subtract out the $3.30 we already paid and our net profit would be $1.70 per share.

In other words, paying money up front with the call debit spread had a higher profit potential ($1.70) than receiving money up front with the put credit spread ($1.60).

Granted, by receiving the money up front in the put credit spread, you are able to earn interest on $4.90 (the $1.60 credit received from selling the credit spread plus the $3.30 not paid out by buying the debit spread) until expiration. But to generate the 10-cent difference in profit potential between the credit and debit spreads would require an annualized interest rate of more than 6 percent, and brokerage accounts are not paying anything close to that rate on cash balances right now.

Furthermore, the put credit spread leaves you vulnerable to assignment on the $90 put you sold if the stock closes between $90 and $85 at expiration. In contrast, with the call debit spread, if the $90 call you sold is assigned, that would mean you get to sell the underlying stock at $90. This would generate the maximum $5.00 value of the call spread, because your $85 call enables you to buy the stock at $85.

Regarding rolls for a call debit spread trade, Jim will consider rolling if:

1. the timing is no more than three weeks prior to expiration with negative net theta (i.e., theta on long option is larger than theta on short option), or
2. an ex-dividend date is one or two days away, the short call strike is in-the-money, and the dividend amount is greater than the time-value remaining on either the short call strike (conservative, very low risk of early assignment following this rule) or the corresponding put strike (aggressive, slightly higher risk of early assignment following this rule).

If no dividend capture is involved, getting assigned early on a debit spread is a good thing!

Jim also says it’s better to deal with assignment costs at the end of a successful trade than during an unsuccessful trade. With a call debit spread, you only get automatically assigned on both option legs at the very end if the trade is a maximum winner and no further rolls are required. And you can close out for regular commissions prior to automatic assignment if you want to. So it’s a key benefit of call debit spreads that there is no forced assignment at the worst possible time and at the worst possible liquidity of the remaining long leg. In contrast, with a put credit spread, you can get assigned early if the trade is a loser and then have to incur additional transaction costs to exit the assignment as part of a roll at the point of the long leg’s worst liquidity.

Theoretically, put credit spreads and call debit spreads should always offer the exact same risk/reward (adjusted for interest rates). But sometimes one is superior to the other. For example, Jim inclines toward:

• a put credit spread when the short-leg strike price (i.e., the leg that you sell) is closest to the current stock price (unless the call strike is in-the-money and ex-dividend date is during trade duration).
• a call debit spread when the long-leg strike price (i.e., the leg that you buy) is closest to the current stock price.

Bottom line: Income traders are often tempted to trade only put credit spreads because they want income up front, but sometimes paying money up front via call debit spreads is the better alternative. Consequently, it makes sense for Jim to check both spreads thoroughly prior to making his recommendation.

For more detail on this, you can read an excellent article by Alex Jacobson of the International Securities Exchange (ISE) entitled The Hidden Cost of Credit Spreads.