Day trading can be a quick way to capture intraday profits. However, not all accounts are suitable for day trading or can afford the pattern day trader requirements. If a trader has already completed three day trades in the past five trading days, it leaves them with two options when they have a profit on a newly opened position.
1. Either close the position, take the profit, and trigger a pattern day trade label
or
2. Hold the position until the next day and hope the profit is still there.
There is a third option that locks in a profit while still avoiding a day trade. This is done by legging into a debit spread.
Legging into a Debit Spread
A vertical debit spread is created when an investor buys-to-open (BTO) one option and sells-to-open (STO) another option further OTM. Both legs are opened on the same underlying equity and use the same expiration. However, both legs do not need to be opened at the same time.
An investor can instead buy-to-open (BTO) the long leg first and then setup a sell-to-open (STO) order for another option further OTM. The STO order should be placed for a credit greater than or equal to the debit paid for the BTO leg. This is called legging into a debit spread.
Example:
1. Either close the position, take the profit, and trigger a pattern day trade label
or
2. Hold the position until the next day and hope the profit is still there.
There is a third option that locks in a profit while still avoiding a day trade. This is done by legging into a debit spread.
Legging into a Debit Spread
A vertical debit spread is created when an investor buys-to-open (BTO) one option and sells-to-open (STO) another option further OTM. Both legs are opened on the same underlying equity and use the same expiration. However, both legs do not need to be opened at the same time.
An investor can instead buy-to-open (BTO) the long leg first and then setup a sell-to-open (STO) order for another option further OTM. The STO order should be placed for a credit greater than or equal to the debit paid for the BTO leg. This is called legging into a debit spread.
Example:
- BTO September 200 put for $10.00 of debit.
- Instead of placing a closing order for the 200 put, place an order to STO September 195 put for $10.00 of credit.
- When the STO order fills, this will create a September debit spread with a net debit of $0.00. (BTO for $10.00 debit - STO for $10.00 credit = $0.00 net debit)
- The risk on the trade is $0.00. The maximum risk, or potential loss, from a vertical debit spread is the net debit (cost basis) of the spread (BTO leg debit minus the STO leg credit).
- The potential profit is $5.00. The maximum profit that can be earned from a vertical debit spread is equal to the width of the spread minus the cost of opening the spread.
No further action should be taken on this spread until the next trading day. Even placing a closing order the same day opens up the risk of being filled and tagged with two day trades.
The next market day, a closing order should be placed to STC the entire spread for a credit. This order can be placed in premarket or at market open. Regardless of when the order is placed, it should be worked until the position is closed. When locking in a zero cost basis, the current value of the spread is the profit.
Example:
- Holding a legged into debit spread with $0.00 cost basis.
- STC the spread for 3.40 of credit.
The spread was BTO for $0.00 and STC for $3.40 resulting in a $3.40 profit.
The total profit on the position is $3.40 per share, or $340 per contract.
Locking in Profits
This strategy can also be used to lock in profits of a position that was initially intended to be held overnight.
An investor BTO a TSLA call based on an upcoming earnings play. TSLA moves 50 points going into market close and the current position has $25 of profit per share. Instead of using a day trade to close the position, STO an adjacent strike to create a debit spread to lock in a profit. Then BTO a new TSLA call to realign the account for the same earnings play.
Example:
- 7/21 13:15 PM ET TSLA trading at 1560.
- BTO Aug 1560 Call for $150 per share.
- 14:30 PM ET TSLA is now trading at 1610.
- The Aug 1560 Call is now worth $175, equaling $25 of profit per share.
- STO Aug 1570 Call for $170 per share.
This creates a debit spread with a $20 net credit. BTO for a debit of $150, STO for a credit of $170 = $20 net credit. This is now a debit spread with a credit as the cost basis. Depending on your trading platform, this may be shown as a negative cost basis. This is because it is a credit on a debit spread.
Max risk = $20 profit, no risk on the trade. Locking in a credit is a guaranteed profit on the trade.
Max profit = $30: $20 of credit + $10 of spread width.
- BTO the Aug 1605 call for $157 per share. This allows the account to still be setup for an earnings play.
- Net risk of the two positions is $157 debit - $20 credit = $137 of risk per share.
Next Market Day:
- 7/22 9:30 AM ET TSLA gaps open to 1679 due to earnings.
- STC the Aug 1560/1570 debit spread for a credit of 6.70.
Total profit on the spread is the $20 net credit + 6.70 of credit to close = $26.70 of profit per share or $2,670 of profit per contract.
- STC the Aug 1605 call for $195 credit.
BTO for $157, STC for $195 = $38 profit per share or $3,800 profit per contract.
Total profit is $64.70 on a net risk of $137 = 47.2% return and no day trades used.
Credit on a Debit Spread
In the above example, the stock moved enough for the STO leg to have a higher value than that of the debit paid on the BTO leg. This legging in allowed for a credit cost basis when normally a debit cost basis would be held if both legs had been opened at the same time.
When the credit received on the STO leg is higher than the debit paid on the BTO leg, this creates a credit on the spread. This does not make it a credit spread. It is still a correctly constructed debit spread because the STO leg is further OTM than the BTO leg, but instead of holding a debit and risk on the trade, the position now has a credit, no risk on the trade, and a guaranteed profit
If a debit spread with a credit is held until expiration and expires out of the money, the “loss” on the spread is actually a profit equal to the credit held.
When a strike is OTM at expiration, it no longer has any value to it. It has lost all time value and because it is OTM, it contains no intrinsic (ITM) value.
Example:
- The BTO leg for $150 is STC for $0.00 = $150 loss.
- The STO leg for $170 is BTC for $0.00 = $170 profit.
$170 profit - $150 loss = $20 profit per share or $2,000 per contract.
If both legs of the debit spread are in the money at expiration, the profit on the spread is equal to the credit held plus the spread width.
When a strike is ITM at expiration, it only contains intrinsic (ITM) value. It has lost all time value.
Example:
AMZN settles at expiration at 1580.
- The 1560 call is 20 points ITM.
- The 1570 call is 10 points ITM.
- The BTO leg for $150 is STC for $20 = $130 loss.
- The STO leg for $170 is BTC for $10 = $160 profit.
$160 profit - $130 loss = $30 profit per share or $3,000 per contract.
It is not recommended to hold ITM spreads on American style options until expiration due to risk of assignment/exercise.
American vs European Style Options
Most stocks and ETF’s are American style options. This means that if the buyer of an option chooses to exercise or assign their rights they may do so at any time prior to expiration.
Indexes such as SPX, NDX, and RUT are European style options. This means that any exercise or assignment may only occur at expiration.
Trading spreads on European style options, can alleviate the concern of early exercise/assignment. If both legs are ITM, they can only be exercised or assigned at expiration.
For American style options, the closer to expiration and the further ITM the STO leg is, the more likely it is to be exercised/assigned. This is why building time into the position is beneficial by using an expiration at least 2-3 weeks out.
Additional Information
This strategy works best on long options, BTO a call or BTO a put. It is not recommended to be used to lock in a profit on an existing debit or credit spread.
While you can use this strategy to leg into a credit spread, debit spreads tend to be more efficient as credit spreads rely on rapid time value decay so generally require sooner expirations.
The legging in strategy works with any spread width. However, the larger the spread width the further the underlying will have to move for the STO leg to be at the same value or higher than the cost basis of the BTO leg.
When legging into wide spreads if you can lock in a cost basis less than the current spread value you still have profit potential.
Legging into a debit spread is an efficient way to avoid day trading but still guarantee yourself a position that can be closed the next market day for a profit. As long as the debit spread is not at expiration or extremely far out of the money, the spread should have value to it. A zero cost basis debit spread can be closed for a profit equal to the current value of the spread. While locking in a credit on a debit spread results in a guaranteed profit equal to the credit on the spread plus the current value of the spread.
