Friday, May 4, 2012

Using Debit Spreads To Increase Profits And Reduce Volatility

A debit spread is a useful tool to have in your options trading arsenal for a couple of reasons. It substantially reduces the volatility in a trade, while still retaining a substantial potential reward. When compared to something like a credit spread, where you could end up risking or for every that you take in, or say a straight call or put where you can end up earning many times your money for every dollar you risk, but have to deal with extreme ups and downs, the debit spread lies someplace in between these two strategies.

Credit Spreads
A credit spread can be a useful tool because it can provide a consistent and predictable income, by selling out of the money spreads. However the obvious problem with this lies in the fact that in doing so you are risking many more times the amount of money you hope to gain. In other words one loss on an out of the money credit spread can easily wipe out the profits from three or four trades. The advantage in these however is that with each passing day the time value decays, which works in your favor so that the stock doesn't actually have to go any place in order for you to make any money.

Buying puts and calls outright is the most common strategy for most investors. While this has the distinct advantage of leverage and the ability to earn many more times than the amount invested it does come with a price. Huge swings back and forth and extreme volatility. One day you're up the next day your down. Your timing has to be spot on much of the time or a winning trade can quickly turn into a losing one. In a trending market these are the best (forgive the pun) option, but in a sideways market it feels like you're on a roller coaster. It can be doubly frustrating when a stock moves in your favor, but the option does not due to time value decay or because it was overpriced based off of its implied volatility to begin with.

Debit Spreads
So that brings us to the debit spread. Although it lacks the staid slow moving consistent profits that the time decay from credit spreads can bring, it does have the advantage that you can profit many more times than the amount risked without the ups and downs from just buying puts and calls.

To create a debit spread is simple. Let's take a look at the exchange traded fund (EFT) on the Nasdaq (QQQQ) as an example-
Let's say that it's the beginning of February and we are Bearish on QQQQ, so decide to purchase the June At The Money Puts. The ETF is trading at .00 so we purchase the .00 June Put for .80.
We then sell the June Put for .45 giving us a total debit of .35 (2.80-.45). So our maximum loss here is what we paid for the spread .35. If at the end of options expiration the ETF has fallen to a price of .00 or less we would have realized our maximum gain of .65 (High strike price-low strike price) (Debit) or (.00-.00) -(2.35) =.65. So our maximum possible gain is almost 3 times our maximum possible gain here.

Maximum Profit = (Higher Strike- Lower Strike) - net debit
Maximum Loss = Net Debit
Breakeven for call spreads = lower strike + net premium
Breakeven for put spreads = higher strike - net premium

There are a few things to remember when using debit spreads.

1.Options lose their value fastest from time decay during the last 4 weeks until expiration, so make sure to use options that have at least 3-6 months or more.

2.Always check historical vs. implied volatility. If the implied volatility is low relative to historical volatility then we want to be a buyer of options because they are undervalued. If the implied volatility is high then we want to be a seller of options because they are overvalued.

3.Obviously do your research, a bit of fundamental and technical analysis and have a reason for believing why a stock is going to move up or down.

4.Use good money management. I usually use a mental stop loss and get out of the trade when the spread has lost 40-50% of its value.

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