If you've tried to buy calls and puts to speculate on a stock's direction, you may have found it sounds a lot easier than it really is. Don't worry; there's nothing wrong with you. Many people have felt this way and experienced similar struggles, but there are ways to control risks, reduce losses and increase the likelihood of success when trading long calls and long puts. Debit spreads are an easy-to-understand and simple-to-construct form of hedging. (If you need a refresher on options, be sure to check out our Options Basics Tutorial.)
A Spread by Any Other Name
Spreads can seem daunting at first because they are called by so many names that new option traders may become easily intimidated. First off, a debit spread is called such because it requires spread buyers to take money from their accounts to pay for it. Thus, they are also called long spreads. You can be long on a call if you're bullish or long on a put if you're bearish. Therefore, it is common to call them long call spreads or long put spreads. Because we buy calls when we are bullish and puts when we are bearish, they are also known as bull call spread or bear put spreads.
Perhaps the most confusing term that comes with spread trading is the adjective "vertical," but understanding how a spread is constructed will help clear up this confusion. For example, let's suppose we are looking at the stock XYZ, which is currently trading at $52 per share. We are bullish on XYZ, which means we want to purchase a call option. The current month 50 strike is selling for $3.50 per share or $300 per contract. To reduce this contract's cost, we'll sell the current month 55 strike for $1.25 per share. Because both the long and short contracts are in the same month, we say the spread is vertical.
Trimming the Hedges
In the example above we purchased a call for $3.50 per share, which means we could lose the entire amount if the stock turned bearish and we couldn't get out in time. We also need the stock to move above the strike price at least enough to cover the option's cost to break even at expiration, which means we need the stock to move up to at least $53.50 to ensure some type of profitability. If we add the hedge by selling the $55 strike price, we reduce the call's cost to only $2.25 per share or $225 per contract. As you can see, we reduced the potential loss amount and we only need the stock to move above $52.25 to break even. At this point, the break even point is only 25 cents away, so our probability of success is larger because we don't need as big a move in the stock price.
We can see that selling a call out in front of a long call has reduced our downside risk and increased our probability of success, but it has also countered in large part a huge frustration associated with long positions - time melting. In the example above we paid about $1.50 in extrinsic value and $2 in intrinsic value. A large portion of the extrinsic value is made up of time value. Time value, also known as theta, melts a little each day. In this case we greatly reduced the effects of theta by reducing the amount of extrinsic value, which again reduces the amount of loss if the stock does nothing. (Learn more about theta in our tutorial Option Greeks: Theta Risk and Reward.)
Probability of Success and Risk to Reward
Your probability of success increases depending on the selected strike prices. Like in most investments, those with the highest probability of success also tend to have a lower reward compared to risk. Those with a low probability of success will have the highest reward compared to risk.
Let's look at an example using a bear put spread. We will assume that we are bearish on ABC, which is currently trading at $44 per share. The 50 strike is currently selling for $6.75, while the 45 strike has a premium of $2.50. We can purchase the 50 and sell the 45 to create our spread. This means our total debit is $4.25, with a potential profit of 75 cents per share or $75 per contract. This is a return of 17.6% (75/425 = 0.176). Because the stock is already at $44 per share, we are already in the money (ITM) on our trade. We just need the stock to stay below $45 and we should collect the entire spread at expiration. Our probability of success is greater because the stock could fall, not move at all or even increase a dollar in value and we could still be successful. Of course, if the stock rallies, we have the potential of losing all $4.25, but that is still less than the $6.75 we started with.
If we want a higher reward, we may choose to purchase the 45 strike at $2.50 and sell the 40 strike at $1 for a debit of $1.50. This is a very inexpensive trade; however, the probability of receiving the full potential is small. The stock would have to fall all the way down past $40 per share to get the maximum profit of $3.50. However, as long as the stock dropped lower than $43.50, you could still profit.
Finding an Exit
The closer options get to expiration, the less extrinsic value they have and the more sensitive they become to price changes. This effect is known as gamma risk. The option's measure of movement in relation to the stock is known as delta and the change in the option's delta in relation to the stock movement is known as gamma.
The week of options expiration is known for being a particularly volatile time for stocks because many investors and institutions are unwinding or rebuilding positions. This means your profit can quickly turn into a loss or your loss can turn into an even bigger loss if you aren't careful. Also, your chances are higher that your short options could be exercised and you will be assigned. Although the risks are set, these things will bring added frustration so it's a wise practice to close your trades about four to 10 days prior to expiration. As well, beware that deeper ITM spreads tend to have wider bid/ask spreads, which will eat away at your profitability. (See our tutorial: Option Greeks: Gamma Risk and Reward to learn more.)
One last important note: many traders get into options because of the large gains that can be made. Whenever you hedge a position, you usually cap the potential gains. In spread trading you can only make the amount of the difference between your strike prices minus the debit. If you are expecting a large move in the stock, then spread trading may not be the most effective choice. However, if you are more concerned about protecting against losses, then spread trading is for you.
Be sure to check out our Option Spreads Tutorial to learn about other option strategies.