Conservative Options Strategies in a Directional Environment: Debit and Credit Spreads

2017-11-21 | Danielle Shay Gum

The market is constantly evolving, and as such, our trading strategies need to do the same. Here at Simpler Trading, we exhibit a variety of income trading strategies, as well as directional positions and setups for choppy markets. Being a successful trader comes through an in-depth understand of varying market conditions, setups and strategies, and then applying those continually that work for you. While the market has maintained a strong bullish trend overall for the past 7 years, for the past three months, the market has basically gone straight up. Minus a few days where we’ve seen a slight pullback in the S&P Futures to the 21-period exponential moving average, and two days where we even pulled back to the 34-exponential moving average (still regarded as a completely normal pullback within the context of the trend), they have been hugging their 8-period exponential moving average since the end of August.

S&P Futures Daily Chart – November 20th, 2017

(Click on the image below to enlarge)

So, this leads us to the obvious – what type of trading strategies work the best in this trading environment? Well, it depends on your risk parameters and account growth goals. For me, I’m a conservative, directional trader, and I love trading directional charts. One way that I especially love to do that, is by using credit and debit spreads.

I like using credit and debit spreads to trade directional charts because:

  1. You can’t change the price of a long call, you can only select varying strikes and expiration dates. With debit spreads, you can take the risk of a long call and cut a third of the risk off by turning it into a debit spread. Debit spreads allow you to play directional setups on stocks where the long options may be too expensive or carry too much risk for you.
  2. I can clearly define my risk as well as my reward scenario. When you buy a long call, you should go into it risking the debit paid, and with a target price in mind. But, you’re still risking the debit paid. With a spread, my platform tells me exactly how much I will lose if I’m completely wrong, or if I’m right. I can adjust my strikes and number of contracts to allow me to get a 1:1 or 2:1 risk/reward situation, whereas on a long call it’s not as common that you can risking one to make one, or 100% on your long option.
  3. If you don’t want to buy a long call, and if you don’t want to buy a debit spread, you can always sell a credit spread which is the least risky way to play a directional chart. I love watching premium flow into my account through theta decay!
  4. Debit and credit spreads allow you to make more consistent money when you’re right, and are much more forgiving when you’re wrong.

Case in Point – Red Hat, Inc. (RHT)

Here we have one of my favorite directional setups. A bullish chart, a bullish market – and then we have squeezes across multiple time frames.

RHT – Daily Chart – 11/14/17

(Click on the image below to enlarge)

On this chart, you can see the bullish trend on the daily chart, in conjunction with the squeezes on the daily, 195-minute and 78-minute charts.

To trade this chart, I did decide to buy two long calls. This setup calls for me to get a bit more aggressive, so I did purchase some calls, but I also added a put credit spread.

Trade Tab – Options Positions – 11/14/17

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In my trade tab, you can see that I coupled my long calls with a conservative, theta decaying put credit spread. By selling a 122/120 put credit spread, I could take in premium while I was waiting for my long calls to gain.

Trading Results

For my put credit spread, I initially sold this for a credit of $0.77 on November 7th, 2017. I exited the trade 7 days later, on November 15th, 2017 for a $0.15 debit. This trade didn’t quite have the 1:1 risk/reward situation that I like, but taking in a $0.77 credit on a spread that is $2 wide is still a pretty good situation. This trade allowed me to make 80% of max profit on the spread within a week. Of course, had I let it go further to expiration, I could have made the last $0.15, but I prefer to take my money and run.

As for my long calls, I purchased both for $4.60 on November 8th, 2017. I scaled out, taking the first off of the table at $6.30, and the second at $6.80, when price hit the 127.2% and 161.8% targets. RHT has continued past these two targets, and all in all, I could have made more on my long calls if I held longer. However, I do my best to remain disciplined and the 161.8% target – this is a lower probability target, and once we hit these levels, I was happy to take my cash.
All in all, I pocketed $186 while risking $369 on the spread, and I pocketed $390 on the calls while risking $920. That makes for a nice total profit of $576 with a total risk of $1289.

Conclusion

Looking back, I could have placed a few more contracts of the put credit spread to bring in more theta decay, but, this is how I traded it and it worked out just fine for me. I like placing conservative, put credit spreads on my directional long plays because of the risk/reward situation, and because they are fairly low-stress trades. They are particularly nice for newer or more conservative options traders who don’t want to buy long calls, and would prefer to turn those long calls into a debit spread or sell a put credit spread. Also, using these options strategies is a great way to learn how to trade directional setups in a way that really defines your risk. In this example, I risked less than I risked on the long calls, but I also made less. Of course, like I noted, you can always sell more contracts or widen your spread to bring in more premium. That’s just how it goes! It’s up to you to decide what type of trader you want to be, and what type of strategies you want to employ to reach your goals.

If you’re interested in learning more about debit and credit spreads, join one of my favorite trading mentors, Bruce Marshall, in his class that will focus on the directional application of credit and debit spreads in our current market environment. Click here for the link!