I don't know the answer to that question. I'm trying to resolve that issue for myself, so I thought both newbies and experienced options traders might be interested.

A debit spread is one in which you pay a debit, so you would be buying a long call and selling a cheaper call at a higher strike or buying a long put and selling a cheaper put at a lower strike. The trade is one with limited risk but also with limited gain. If your underlying takes off in the direction of your long, your expiration gains will be tapped out at the distance between the strikes x 100 - the cost of the trade x the number of contracts.

For example, imagine that with the OEX at 634.42 near the close on November 21, I had bought a weekly put vertical: +1 NOV5 12 635/-1 NOV5 12 630 for $2.05. If the OEX dropped all the way to 628 at expiration of that weekly, I would still gain only $5.00 x 100 - $205 = $295 minus commissions, since $5.00 is the distance between strikes. It wouldn't matter how far below 630 the OEX fell, that's still all I would gain.

Why buy a debit spread, then? Why not just decide how much you're willing to risk on a call or a put and buy that, without limiting your possible gain? You're still limiting your risk to what you paid on the single long option you bought.

Several reasons exist. Obviously, you pay less for the debit spread than you would for the long option alone at a certain strike. In a spread, the cost of your option purchase is offset by the premium you take in by selling an option. You lessen the impact of the passage of time and may be benefitting from the passage of time, depending on where the underlying's price is in relationship to your long option.

However, most of the time when I'm buying a debit spread, that's not my primary concern. I use call debit spreads to hedge upside risk in my butterflies after the delta risk in the butterflies has gotten more negative than I want it during an upside move. I buy them because of the way volatility tends to act when prices on my underlying are steadily climbing.

Volatility tends to drop when prices are climbing, and that means that a positive-vega long call may be leaking extrinsic value even while the underlying's price is climbing. That's not a problem in the deep-in-the-money calls I buy at the inception of the trade because they have little extrinsic value to decay. However, when I might need something with a positive delta of 20 after the underlying has moved higher and my trade is too negative delta, for example, I'm not going to want to buy a call that deep in the money because it would be overkill. It would make the trade too positive delta when I just meant to flatten the delta risk a little.

If I were trying to hedge with a long call, I'd be buying something that had only extrinsic value to get that delta. The drop in volatility would then be working against the long call's profitability.

The long call I hypothetically might have bought may not hedge as well as I hoped unless a move is large and quick. My kind of trade is probably going to be open two or three weeks. A debit spread is not going to be as responsive to changes in implied volatilities because it involves buying some long volatility and selling some volatility. Therefore, the debit spread may be the better hedge in my particular situation with my particular needs in mind and perhaps it is for some of your trading situations, too. I also use debit spreads for the speculative, equal-risk/equal-reward trades every now and then, so they have several uses in a trader's repertoire.

Let's set up a theoretical butterfly and look at how different choices of debit spreads impact the profit-and-loss charts and the Greeks of the trade. I'll show you what I've been considering. This isn't a trade I'm suggesting, nor one I traded. I haven't traded the OEX for many months. I'm using this as an example only.

Let's imagine that on Monday, November 14, at about five minutes before the close with the RUT at 618.19, I set up an OEX 640/610/570 put butterfly for $6.15/fly. Note that normally, I would have set up a balanced butterfly with the wings equidistance from the center of the butterfly so that I wouldn't incur margin on both sides of the trade. However, when I roughed out this article, I made a mistake. As it happened, this mistake helped the trade, because it lowered risk on the upside and that was the direction the OEX was to head. However, unbalanced wings change margin requirements on many platforms.

By Friday, November 23, 2012, the OEX price had moved outside the expiration breakeven, and the white "today" or "T+0" line was sloping quite strongly to the right side of the then-current price late morning that day. The trade probably should have been adjusted sooner and would have been, if it had been a live trade, but I was following it at irregular intervals for the purposes of this article. The hypothetical trade definitely needed some consideration before the weekend, with yet-another "solution" to the Greece problem expected that Monday. No one knew at the time whether such a solution would be offered that Monday, any more than it had been the previous week, or whether any press conferences would send markets higher or lower.

Chart of Theoretical OEX Butterfly as of 11/23/12:

This hypothetical position is a 4-contract butterfly, and we can see that, for each $1.00 that the OEX moves up, the position is theoretically going to lose about $42.74 since the delta is a -42.74. Moreover, this is a negative-gamma position, so that delta is going to get more and more negative as the OEX moves up. The loss is already quite heavy and will get heavier fast. Even if you're not a person who knows about or cares about the Greeks of the trade, you can see all this in the shape of that today line.

Our hypothetical trader might be reluctant to move the butterfly until after the holiday weekend, when more traders returned to the desk and we had more information about fiscal cliff debates and the issues going on in Europe. Here's an example of what a 3-contract 630/640 call debit spread could do to stabilize the position.

Butterfly Trade with a 3-Contract 630/640 Debit Spread Added:

Theta wasn't hurt. Vega is more negative, which means that if the volatilities drop with a continued grind higher, the overall trade will actually benefit more, at least at this point before expiration. Of course, if the OEX had rolled over and tumbled down hard, the implied volatilities might have risen and that would have hurt the trade overall, but you can see that the white today line allows for some downward action without too big an immediate hit.

The big change is in the delta value. Notice that the delta is not as negative, at only -7.16. This is reflected in the change in the white today line. In the vicinity of the current price, that line is fairly flat. Theoretically, losses don't look as if they would escalate until the OEX fell below about 622 or maybe rose above 645 or so, giving the trader a little leeway to watch a test on Monday. Of course, these are theoretical profit-and-losses, and the actual trade's PnL may not reflect what's seen on the chart, at least exactly.

Why did I choose to buy the 630 and sell the 640 call to set up the vertical in this hypothetical trade? I've been experimenting with placing these hedging call debit spreads so that the sold strike is at the money, since the ATM's tend to have the most extrinsic value. As I was roughing out this article on that Friday, November 23, 2012, the following chart shows intrinsic and extrinsic values for OEX JAN13 calls.

Intrinsic and Extrinsic Values for JAN Calls:

We can see from this chart that the 640 call had the biggest extrinsic value, as we expected. We know that ATM options usually do. So, my thought is that selling the most extrinsic value and buying less extrinsic value might be a good tactic.

That's not the only consideration. In the past, I have often wanted the trades to be as clean as possible, and I've placed the debit spreads so that I'm buying the call at the same strike at which I'd sold the puts, the center part of the butterfly. One benefit to doing that is that, because the OEX's price is so far beyond the sold strike of the call debit spread, the spread had actually gone positive theta. However, because the 620 doesn't have as much extrinsic value to sell, this spread costs more to open and doesn't have as much money to gain until expiration. Its positive deltas were not as high as with the 630/640 spread, so it didn't help as much to flatten the trade to the upside.

Trade with 610/620 Call Vertical Instead of 630/640

Could I have bought a single 30-point-wide call debit spread instead of three 10-point wide ones, thereby incurring fewer commissions? Yes, I could. However, the wider a debit spread is, the more it acts like a regular old long call purchase. I have used 30-point spreads, but I haven't used any wider than that. I prefer to stay at 10-20.

Another drawback to that, also, is in the case in which I might need to lower deltas and could peel off the three call spreads one by one. It's also possible, of course, to narrow a 30-point call debit spread to a 20-point one. For example, if I had elected to buy a 610/640 call debit spread, I could narrow it to a 610/630 one by placing a call credit spread order to buy the 640 and sell the 630. With think-or-swim, the brokerage I use for most of my active trading, I can easily put in that order although it requires closing one trade (the 640) and opening the other (the 630) in a single transaction. Some brokerages don't allow that process, however. You'd have to first buy back the 640 and only then sell the 630, perhaps incurring more slippage.

What if you had begun buying those debit spreads as the OEX had begun moving up, not all at once? Would you place them all at the same place as the original, or stagger them so that each of the sold strikes is at the new ATM? There's no one right or wrong way. For me, I'd like to keep the trades as clean as possible with as few separate open strikes as possible, so I'm likely to just add new contracts to the same strikes I already have, whether it's the absolute optimum choice. Remember that mistake I made when originally setting up this hypothetical trade? I like to think I would have caught that if this had been a live trade and I were going through my checklist before entering it, but the fewer opportunities for such mistakes, the better. When it's time to close out a trade, it's easier to close out three contracts of the same spread in a single transaction than to close out three different spreads of one contract each. Three different trades provides two more opportunities for mistakes. However, I do sometimes widen my original spreads out instead of adding more.

Other concerns exist. For example, a glance at the bid/ask spreads on an options chain shows you that the bid and ask tend to be tighter near the money and can be quite wide with a deep-in-the-money option. While I don't tend to have problems selling my deep-in-the-money single long calls I buy at the inception of the trades to flatten delta, I do sometimes experience difficulties selling those call debit spreads and have to work the trade for a while. Is that because sometimes those spreads include an option that is now quite deep into the money with a wide bid/ask spread while the other has a tighter bid/ask spread? Some option traders think so, although I wonder if it doesn't have more to do with the direction of the market at the time.

Options are so flexible that we have a lot of choices. For example, debit spreads can be constructed so that they help hedge risk on another type of trade, perhaps stabilizing it so that it doesn't require a more difficult adjustment. With those choices come opportunities, and sometimes those opportunities are opportunities to make a mess of a trade. Consider whether you'll make less of a mess with fewer strikes open in the same trade. Think about what the goal of using a spread might be and experiment with analyze or profit-and-loss pages to determine which debit spread might be best for your purposes. When I'm using them for speculative purposes, for example, I'm looking at price charts and looking for resistance or support and using that information to construct the debit spread I want. Different type of trade: different needs from the debit spread.