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The Benefits of Debit Spreads By Len
Yates – President, OptionVue Systems International.
Directional traders have a lower
octane alternative to simple call and put purchases -- debit spreads.
Many traders are first attracted to
options, and first use options, for directional trading. Directional trading is where the
trader believes he knows which way a stock, index or future is going and
opens an option position to take advantage of the expected move. More often than not, this option
position is a simple call or put purchase. However, buying calls and puts is
high-octane trading.
Traders should consider the benefits
of spreading. A spread is
constructed by buying an option and selling another option of the same
type (call or put) on the same underlying. Usually the two options are of the
same expiration month. (Such
a spread is said to be a "vertical" spread because the options differ only
by strike, and in the array of options you picture the strikes running
vertically.)
When the option bought is more
expensive than the option sold, the spread is said to be a "debit" spread
because its opening results in a net debit to your trading account. When the option sold is more
expensive than the option bought, the spread is a "credit" spread. However, we will only be
discussing debit spreads in this article.
How does a debit spread work, and
why use it?
When you buy a debit spread, you are
essentially buying the difference, or spread, between the prices of two
options. You are expecting
that with the right market move, that price difference will widen,
resulting in a profit. A
trader who buys a debit spread in calls expects the underlying to go up in
price. As the underlying goes
up, both legs (options) of his spread will increase in price, but the
higher priced leg increases faster, thus widening the spread.
Conversely a trader buys a debit
spread in puts when he expects the underlying to go down in price.
One reason a spread is attractive
relative to a simple purchase is the size of position you can afford to
own. For example, say the
following two call options on a stock currently trading at $80 (of the
same expiration month):
Strike
Price 80
5.50 85
2.80
With $5,500 you could only afford to
buy 10 of the in-the money options. However, you could afford to enter a
20-lot of a debit spread between these options, as the spread (difference)
is currently 2.70.
As when buying an option, you may
lose the amount paid for a spread and no more. However, unlike buying an option,
where the value of your position could theoretically increase without
limit, the value of a spread can increase only to the difference in the
strikes.
For example, a spread made with the
above options can only go to a maximum value of 5. Buying it now for 2.7, it could
either go to 0 (both options out-of-the-money), 5 (both options
in-the-money), or any price in between (the 80 option in-the-money and the
85 option out-of-the-money).
The illustration below displays the
performance of a call debit spread in contrast to a simple call purchase
with the same amount of capital, with the price of Forest Labs stock
currently at $80.65:
A spread behaves very differently
than a simple purchase, and because of that, traders must decide if it is
appropriate for their psyche.
Again, a spread has minimum and
maximum outcomes. Thus, much
like a Las Vegas bet, you either win or lose. The angst of picking a selling
price, so important with simple option buying, is abated.
Simple option buying
requires greater strength of discipline. A simple call or put position is
like raw energy. It responds
dramatically to every move in the underlying. Thus the trader must add his own
discipline -- objectives, stops, and perhaps trailing stops.
In contrast, spreads allow the
trader more time to make an exit decision. Spreads may even be held all the
way to expiration without concern over rapid time decay. In fact, if the underlying has
made the move you expected, your spread, now in-the-money, makes
money with time.
In times of exceptional volatility,
when options are more expensive, the option buyer is at a
disadvantage. However, the
option spreader gets to neutralize this effect by selling an overpriced
option at the same time as buying an overpriced option.
One caveat with spreads: if the underlying quickly makes a
move in the direction you expected, you may be disappointed to see that
your spread has not gained much. That's because for the spread to
achieve its full potential, much of the gain will only come through the
passage of time. Not only could this be too boring for your trading
psyche, it also risks giving the stock time to slip back.
Also note that since spread trading
involves trading more option contracts with the same capital, it incurs
larger commission charges.
Bottom line: For directional trading, use a
strategy that best matches your trading psyche. A lot depends on how involved you
want to be, or can afford to be, in watching the markets. Your trades need to be interesting
but not anxiety producing. If
you find that buying calls and puts makes you too emotionally involved,
you may need to consider switching to milder, more casual spread
trading. Successful traders
are unemotional, unstressed traders.
* Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor.
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