One advantage of trading options (that I have constantly reiterated on this series of blogs) is that they are truly unique. Options provide flexibility in a variety of market conditions. Spreads, straddles, strangles, and straight call/put purchases can be utilized in different market environments. This particular post will focus on debit spreads.
Debit spreads lower the cost basis of an option, and the strategy involves selling one option to finance the purchase of another. This can be attractive from a premium buying standpoint—but the obvious downside is that your profit potential is capped at a certain strike (depending on the option sold).
Generally speaking, I’m not one to trade options using debit spreads, as the major caveat is that you are capping your upside. However, the use of debit spreads in select market environments is certainly beneficial, and if you anticipate the option to make a move in one direction, (but not necessarily an explosive move) a debit spread is a good strategy to understand.
Initiating a debit spread is easy. Yahoo! (YHOO) is featured below on a daily chart. This data was as of the close on Monday, April 8th, 2013. You can see that YHOO recently hit the $24 mark, before pulling back from this new 52-week high. Let’s say that, as a trader, we anticipate YHOO to make another run at this level, but that it may stall at or just above the $24 level. Essentially, we have conviction on direction, but are less certain on the magnitude of the move. Also, given that the current market environment seems to be trading between the recent new all-time highs of 1,571 and the support level of 1,550, one could certainly make a case for a “range-bound” scenario in the near-term.
We decide to purchase an in-the-money (ITM) option—the May 23-strike call. If you look below at the options data pulled from eSignal (again, this data was after the close on 4/8/13), note how this option was offered at $1.14. However, we decide this option is too expensive, and we want to offset the cost by selling a further out call—the 25-strike which is bid at $0.34, offered at $0.35. Market makers will always sell to you at the ask, and buy from you at the bid—this spread is the price you pay for liquidity in the options market. If we purchase the 23-strike call at $1.14 and sell the 25-strike call for $0.34 (at the bid) this brings our cost basis down to $0.80. Our brokerage account would be debited $0.80 for each spread we initiated.
For the option to double (100% gain), $24.60 would need to be achieved by the expiration date ($0.80 x 2 = $1.60—you then add this to $23). However, any move above $25, and the option we sold would be in-the-money. This is where our profit level would be capped. If YHOO moves to $26 by expiration, our 23-strike call would be ITM by $3.00—and the 25-strike call would also be $1.00 ITM, thus negating the unanticipated, outsized move that YHOO made in a rather short timeframe. Ideally, YHOO would close below the 25-strike by expiration, allowing us to avoid assignment on the option, and still take in profits from the move above $23.
Again, I’m not one to trade debit spreads, as I personally dislike the idea of having my profit potential on a trade be limited. Putting on a spread is absolutely a cost-effective way to trade options, and a debit spread is a rather common method of trading. Even if you don’t utilize this strategy, learning this strategy (as well as the many others) will add value to your understanding of options and how to successfully trade them.