Many traders come to us with experience trading stock, and possibly calls or puts. Learning about more complex options strategies, such as credit and debit spreads, can be daunting at first. I wanted to do a quick summary on this topic because of all the questions I’m receiving.
Resources: I highly recommend checking out our free Options Bootcamp in which Henry discusses spreads, butterflies and condors. It’s only an hour long, and it will give you a great overview on these strategies. Here is the link to an additional free class called Back to Basics in which Henry and Bruce also discusses debit and credit spreads in detail.
Debit Spreads (verticals) – Debit spreads are placed when you want to be long, and enter the trade in the direction of the trend. These are placed in instances when buying a long call or put is of interest, but a spread is chosen due to the benefits of a spread. When you purchase a debit spread, you are buying premium for the long option, and selling a second option against it to reduce your cost basis, lower theta decay and neutralize volatility.
Benefits of Debit Spreads:
- It’s a defined risk strategy that is cheaper than buying a long call/put.
- John usually uses them when he is looking for a directional move, but not an explosive directional move.
- A debit spread will lose less money than a long call/put if you’re wrong. You’ll also make less money if you’re right.
Here is a trade alert from the Gold Room sent by John:
BOT +10 VERTICAL EA 100 (Weeklys) 3 FEB 17 84/87 CALL @1.20 CBOE This is a call debit spread that expires this week. Earnings are today after the close.
This trade is a call debit spread on EA. Since it says ‘BOT +10 VERTICAL,’ that makes it a debit spread. We are buying the $84 call and selling the $87 call against it to reduce our cost basis, and we spend $1.20 per contract. It is a bullish bet that will be less impacted than long calls through an earnings announcement. Ideally, EA will have a solid earnings report, and our calls will go up overnight.
Credit Spreads (verticals)– Credit spreads are placed when you want to sell premium versus buying premium (as with long options and debit spreads), and collect theta overtime as it decays. You are selling an option, and then buying a long option against. This is for protection against assignment, and to define your risk. If you’re bullish on a stock, you can sell put credit spreads. If you’re bearish, you can sell call credit spreads.
Benefits of Credit Spreads:
- High probability way to trade directional moves.
- You can adjust the width of the spread and contract amounts to create a risk/reward ratio that you’re happy with. John likes risking one to make one.
- If you’re betting on a directional move but the stock moves sideways, you will still make money.
- If you’re betting on a direction move and you’re wrong, you used a defined risk strategy, and most likely lost less money than you would have if you bought long options.
Here is a trade alert from the Gold Room given by Henry:
SOLD -5 VERTICAL NFLX 100 (Weeklys) 10 FEB 17 140/137 PUT @1.10 ISE [TO OPEN] FILLED – Note the PCS is 8 DTE
Since it says ‘SOLD -5 VERTICAL’, that means it’s a credit spread. It is a put credit spread, which also means we are bullish NFLX in the immediate future. For this trade, we sell the $140 puts, and buy the $137 puts, giving us a credit of $1.10. Ideally, NFLX will remain above $140, preferably going higher, and the premium we sold will decay, with cash going straight into our account.
Checking Your Risk
Think of each vertical as one trade – put them on and take them off together, especially when you’re new. When you close one half of the spread, it changes your risk profile.
John likes to target a 1:1 risk/reward ratio on these trades. He position sizes according to max loss he is willing to incur, and he doesn’t risk more than he is willing to lose. He has specific parameters for exits depending on the setup he used to enter the trade.
You can adjust the width of your spreads to determine how much you’re willing to risk. For example, if John is selling a credit spread $10 wide, and you’re not comfortable with the risk that entails, you can always tighten the width of the spread to incur less risk.
When partaking in spread trading. If you’re not sure what the consequences of leaving a trade on through expiration are, exiting the trade is the safest bet.
Calculating Profit Targets
Generally, John likes to target 80% of max profit, and then he’ll take off the trade. A more conservative profit target is 50% of max profit.
How do you calculate 80% of max profit?
Let’s say you’re selling a $5 wide spread for a credit of $2.50. Your max loss is always the width of the spread, minus what you took in as a credit. In this case, that is a $5 max loss. This trade would give you a 1:1 risk reward ratio. The max profit you can get is $2.50, because that is the credit you took in when you sold the spread. To find 80% of $2.50, you multiply 2.50 x 0.80 = $2.00. Then, you you’re your credit, and subtract 80%. $2.50-2.00= $0.50. Therefore, if you are attempting to take your spread off at 80% of max profit, you could set a Good till Cancel order at $0.50, and wait for theta decay and price action to work in your favor.
Since you’re selling premium with the hope that it will decay and go straight into your account, the hope is that you can buy back the spread for less that you sold it for, to exit the trade with a profit. In the case that the trade goes against you, you will have to purchase it back for more than you sold it for, creating a losing position in your account.
In the case of a debit spread, you’re purchasing premium versus selling it. Your max profit is going to be the width of the spread. For example, you could purchase a debit spread for $2.50, that is $5 wide. The max you could sell it for is $5. To calculate the max profit, you take $5 and multiply by $0.80. The calculation is $5.00×0.80 = $4.00. Therefore, if you pay $2.50, and you’d like to take the spread off at 80% of max profit at $4.00, you’re hoping to make about $1.50 on the spread.
The most you can lose, is the amount you paid. You need the price to raise in value so you can sell it for more than you bought it for. If it losses value, you lose money.
Entering and Exiting Orders in ThinkorSwim
Check out this document on Understanding Trade Alerts for a detailed explanation of placing and closing these trades in ThinkorSwim.