Want an options trading strategy you can utilize regardless of whether you have a large or small account? Consider the debit spread options trade. Take advantage of price swings with capped risk and good profit potential by buying and selling two different call (or put) options at the same time.
By George Papazov
When a trader encounters options for the first time, they are flush with excitement and opportunism. However, there are many myths and misconceptions in the options trading world.
The three most common option trading myths I hear are:
- Options are highly speculative and risky; you can lose EVERYTHING! False, options can actually help you manage risk more effectively when used correctly. If you lose everything it’s because of a lack of discipline, but not because of options themselves.
- You need a large trading account for options. False, you need roughly 10% of the capital you would need to trade stocks, and can make just as much, or more, money!
- You need a math Ph.D. to understand options. False, there is a learning curve, but it’s not as steep or as high as most people think. You can do it!
I could rant about each of these three points in great detail, but I won’t. Instead, I’ll show you an options trading strategy that is simple to execute, and can be applied to your trading artillery right now!
Options Trading Mini Crash Course
Before we begin, it’s important to understand the basic concepts of call and put options, as well as the basics of what an “option contract” is.
–Option contracts give you the right to a possible benefit before a set expiry date, should you choose to exercise it.
–Call options give you the right to buy a stock at a specified price, before the expiry date.
–Put options give you the right to sell a stock at a specified price, before the expiry date.
–The “strike price” is the share price that triggers a benefit for the option buyer.
–Each (1) contract gives you rights to 100 shares.
–Calls and puts have their own trading value, based on the stock price (called the underlying) and other factors such as how much time is left until the option expires and volatility of the underlying stock.
–You can buy and sell options contracts during regular market hours, assuming there is someone else to buy from/sell to.
–Contracts are not listed for every stock. Usually, only stocks over $20 with heavy volume are available for options trading. Check if a stock is “optionable” by viewing the options chain provided by your broker or trading software (or Yahoo! Finance, discussed below).
Let’s step it up a notch and discuss a specific options trading strategy you can utilize whether you have a small or large trading account.
The Debit Spread Options Trading Strategy
Debit Spreads are a fixed risk, fixed reward options trading strategy. You can only lose the amount you pay for the options (controlled risk) and your maximum profit is known before you execute the trade. This is great for your psychology and risk management.
The Debit Spread Trade Process:
1) What is your outlook on the stock, or underlying security?
With this options trading strategy you need to have an expectation of where the stock is headed, and when it is likely to move there. This additional parameter (the when) makes options trading a game of precision.
If you think the stock is going up, or down, in the next few weeks then use this strategy. If you don’t think the stock is going anywhere then this specific options trading strategy isn’t effective.
We need a move to happen!
2) When is this move expected to complete?
Based on the technical analysis, how long will the trade likely take to reach the price you expect it to move to? For example, XYZ Co bounces off trendline support at $50. You draw a trend channel and see that it will likely take about 5 weeks for the stock to reach the top of the trend channel, near $58 resistance.
Now let’s look at a real example.
What assumptions can we make using the chart below?
–Apple stock has taken a beating in the recent downtrend, currently trading at $94.48 per share (as of 2016, when this article was orginally published).
–Assume I (or you) think we are at a bottom, and a bounce to the first Fibonacci retracement at $100 is likely.
–Based on a normal retracement pattern (how long it typically takes the price to bounce how far we need it to), it will likely take until mid-February 2016 to hit $100 (2 weeks from the time of writing).
Note: This assumption is for illustration purposes only. It’s not a trade recommendation or advice. In fact I think Apple is probably going down if it dips below $94.
Now we have a trade!
Expiration date: 2 weeks from now
3) Pull up the option chain for the end of February 2016, and find the calls trading as follows:
Get access to free option chains on Yahoo Finance. It is recommended you use your own broker for seeing options prices though. If the table above looks confusing, see How to Read an Options Table.
Each option trades as its own security, with its own price, bid, ask and volume.
Select the closest call option strike below the current market price of the stock. All call options with strike prices below the market price are shaded in light blue. These call options are “in the money,” because they are immediately profitable to own (not including the cost of the option, called the premium). For example, if you have the right to buy a $94.48 stock for $94 obviously this is a benefit of at least $0.48, which means the option should be trading for at least that price.
So, why is the $94 strike call option trading for $2.26 (the premium) if it only gives you $0.48 of benefit? Because of time! It has time to go up before expiry and accumulate more profits for you. You are paying for the opportunity to make money before the expiry date.
4) Build the debit spread options trade
Step 1: Buy the first strike that is in the money – $94 in this example. This will cost you $2.26 per contract (ask price). Each contract is for 100 shares, so you multiply the $2.26 by 100 and you get a total cost of $226.
Step 2: Sell the strike price option closest to your target level – $100 in this case. This sale will generate $0.39 (bid price) per contract in cash, or $39.
NOTE: Do the debit spread entry steps in order! Selling the option first (instead of second) creates an unlimited loss scenario on that option. BAD! Always sell the option second when opening a trade, and close the sell position first when exiting the trade. Most brokers allow you to execute both positions simultaneously.
Here’s how much you paid for the trade: $226 – $39 = $187.
You only need$187 (plus the cost of commissions) in your account to take this options trade. Notice how using a debit spread reduced the cost base of your position by $39. You paid $187 instead of $226. But there is a catch.
Maximum Profit for Debit Spread Options Trading Strategy
Assume that on February 19th, the expiry date, Apple lands right at $100 like you predicted.
Your profit is the difference between your two strike prices, minus what you paid to execute the trade.
Subtract the $187 you paid to initiate the trade and you have $600 – $187 = $413 profit (220% on your $187 trade).
Compare that to buying 100 shares of Apple stock at $94.48, which costs $9,448. If Apple hits $100 you’ve made $552. That is only 5.8% because you used $9,448 in capital, versus just $187 for the option trade.
NOTE: Debit spreads are for short-term trades. Your maximum profit is achieved if the stock price reaches the strike price of the option you sold, $100 in this example. Your profit is capped at this level. If the price moves above $100 before expiry you will not receive any additional profits. But in return you generated cash that reduced your cost to begin with; this is the trade-off in utilizing a debit spread options trading strategy.
Maximum Loss for Debit Spread Options Trading Strategy
Assume your analysis was wrong. The stock continues to plunge and by February 19th it is sitting at $85 a share!
You were wrong, so expect to lose money. The maximum loss of a debit spread is the total sum you paid to open the trade, or $187 in this case.
Compare that to buying 100 shares of Apple stock. Total cost is $9,448. What is the maximum you can lose? All of it, if the company goes bankrupt (highly unlikely in the short-term, but it has happened, i.e. Enron). If got out at $85, you lost $948 ($9448 – $8500), compared to just $187 with the options trade.
What happens if the share price is between your two option strike prices?
You get a partial profit. Assume you were right it would go up, but by February 19th, it is only at $98.
Calculate your return as follows: $98 market price – $94 option strike price = $4, times 100 (1 contract) = $400.
$400 – $187 = $213 profit (113% on your $187)
Breakeven Point for Debit Spread Options Trading Strategy
The breakeven price is the cost of the trade, divided by 100 and added to the long option price of $94.
So, our cost is $187 (for 1 contract, or 100 shares), or $1.87 per share.
$1.87 + $94 = $95.87. I the stock price trades above $95.87 you make money; if it trades below that you will some lose money, up to $187 in this case.
Options require less capital than owning stock, and your downside risk is capped. The drawback is you have to be right about where and when a stock will move. If you are consistently wrong you will lose small amounts regularly. Your account will eventually suffer death by 1,000 paper cuts.
Another Debit Spread Example
Let’s look another debit spread example from 2018.
Assume you don’t typically like trading pharmaceutical companies because they can have wild swings based on drug trial results or FDA announcements. What looks like a good buy today may be down 50% tomorrow if they fail a drug trial. Scary stuff. With options, you cap your risk at whatever you want. If a buy a stock and it gaps down on you (can’t get out between the price it closed at the day before and where it is trading now) you could be facing a huge loss.
Or maybe you want to hold a stock through an earnings announcement but don’t like the risk associated with the huge move that could occur. Options can help with this too.
The chart of Teva, a drug manufacturer, is a good example of this. The stock was in a downtrend and then had a huge gap down in mid-2017. If you were holding that stock the night before, you woke to a big loss the next day. As an aside: don’t fight the trend.
Come late 2017 the stock had a big rally, which was bigger than the last down leg of the decline. That’s often a reversal signal. The pullback in January 2018 presents an opportunity since the price is starting to rally again in February. This could indicate another rally to the upside. Warren Buffet seems to think so, accumulating a sizable position in the stock after the sell-off.
A target area, $24.50 to $25, is just above the early-2018 high and also near where the stock gapped down to in mid-2017. We assume the stock will reach this area within the next five weeks based on the trajectory of the price. Therefore, we look at options that expire in four to five weeks from the time of our trade (Feb. 16, 2018).
The stock is trading at $20.90, so the nearest in-the-money strike price is $20.50. This option costs us $1.37. If we buy 2 contracts, this costs us 200 x $1.37 = $274, plus commissions.
We sell a call option at our target strike price of $25, but there is no one willing to buy an option at that price, but there is someone who will give us $0.16 at $24.50. We sell 2 contracts and receive $32. One thing to note is that on small dollar amounts, commissions will eat up a chunk of this cash.
Our trade costs $242, plus commissions. This is the most we can lose, even if the stock gaps down to $1.
If the price reaches our target of $24.50, our options are worth approximately $4 x 200 = $800. Minus the cost of the options, we net $$558. A more than 200% return on the capital we used for the trade…or a more than 2:1 reward to risk.
Options can actually tell us how far a stock is expected to move over a certain time frame. The options for this stock indicate that traders expect it to move about $2 between the time of the trade on Feb. 16, 2018, and the option expiry on March on March 23, 2018. That means if the stock does rise from here it may only be trading near $23 at expiry…if we are right about the direction. If the stock is trading near $23 at expiry, the profit is $23 – $20.50 = $2.50 x 200 = $500 – $242 = $258.
Just like stock prices, option prices may change significantly during the day. If trading more than 1 contract, it may not always be possible to get as many contracts as you want at the price shown. This is especially true in stock where this isn’t a huge amount of options volume, as can be seen by options chain above. For some of these strike prices, an option hasn’t changed hands in more than a week. These are all things to keep in mind.
Considerations for Debit Spread Options Trading Strategy
If you think a stock is going to fall, you can also trade it using put options and make money as the price sinks!
It takes very little capital in your account to trade this strategy.
This limited risk and return profile is soothing for new traders, and our students achieve more consistent results with it compared to other strategies.
This strategy takes practice to master, and you can always apply variations to the strategy (choosing different option strike prices or expiry dates, deeper in the money or further out of the money options).
I don’t know you personally, and can’t give you financial advice…but I’m going to give you this advice: PRACTICE this strategy with fake money first. You can trade options for free in a demo account using the CBOE Virtual Trading tool. Use it!
If trading options interests you, check out my Debit Spread Options Trading Course. Hope to See You Soon!
By George Papazov
George Papazov has over sixteen years of trading experience in currencies, stocks, futures and options. In 2012, he founded TRADEPRO Academy to offer traders a complete development package.
Disclaimer: Trading and risking real capital is your decision and done at your own risk. Trading involves a substantial risk of loss.