An option spread is the simultaneous buying and selling of the same type of option (put or call options) to establish a spread between the strike prices. If the premium received on the sold options is less than the premium paid for the bought options, the option trader has created a Debit Spread. The simplest Debit Spreads involve buying and selling the same number of options on different strikes in the same expiry month. We will focus on these simple Debit Spreads. Debit type Spreads are limited loss, limited profit option strategies and are often used in range bound markets. In this article I will give you five top tips for finding the best Debit Spreads.
A Debit Put Spread involves buying put options and simultaneously selling an equal number of put options with the same expiry date but a lower strike price. This is a bearish strategy. If at the expiry date, the underlying price is below the lower strike price of the sold puts, the option trader profits by the difference between the strikes less the initial debit. If the underlying is above the high strike of the bought put options, she loses her initial debit. The breakeven point for the trade is at the higher strike less the initial debit. The trader profits if the underlying is below this point at the expiry date.
Conversely, a Debit Call spread requires buying call options and simultaneously selling an equal number of call options of the same briansclub expiry date, but at a higher strike price. This is a bullish strategy. If at expiry, the underlying price is above the higher strike price of the sold calls, the option trader profits by the difference between the strikes less the initial debit. If the underlying is below the lower strike of the bought call options, she loses the entire initial debit. The breakeven point for the trade is at the lower strike plus the initial debit. The trader profits if the underlying is above this point at the expiry date.
What is the best spread? Simply the one with the highest expected profit per dollar risked. Remember that your risk is limited to the initial debit. So the expected profit can be described as a percentage of the initial debit.
There are a number of aspects that contribute to the expected return of a Debit Spread and my five top tips mostly relate to this…So without further ado, here they are:
- Buy, download free or write a simple spread evaluation spreadsheet to evaluate the Debit Spreads. This will allow you to enter all the basic information and calculate the probability of a profit or loss and more importantly, your expected return.
- Look for Debit Spreads where the implied volatility of the bought option is significantly (greater than 20%) less than the implied volatility of the sold option. As options vary in terms of strike and expiry date, implied volatility is a good standardised measure of an option’s relative expense. Perhaps the greatest edge available to an option trader is to buy cheap options and sell expensive ones.
- Find Debit Spreads with zero or even positive time decay. Normally a Debit Spread has negative theta, that is, it costs you daily in terms of time decay. By following Tip 2 above and buying cheap or low implied volatility options and selling expensive of high implied volatility option, you can establish a Debit Spread with negative time decay.
- If the underlying moves in your favour beyond the strike price of your sold options, be prepared to close the trade to avoid early exercise of the short options. This is especially the case for Debit Call Spreads where a dividend is due to be paid prior to the expiry date.
- Consider using a spread ranking or scanning service to filter through the thousands of Debit Spreads available. These are available from your online option broker or a good option data service. These allow you to set many criteria to search for Debit Spreads according to your own preferences and give you a huge head start towards your goal of finding the best Debit Spreads.
You now have your five top tips to finding the best option Debit Spreads. Debit Spreads are an underrated strategy that if approached in systematic, disciplined way can be very profitable.
Ned Calvert – Volatility Tracker
Volatility Tracker is an option trading [http://www.impliedvolatility.com.au/option-trading] resource dedicated to providing traders of Australian Exchange Traded Options (ETO`s), with access to volatility analysis and option trade selection tools essential to long term option trading success.
Volatility and the underlying share price are the major factors affecting the profitability of most option positions. Time decay also becomes more important as the expiry date approaches. However, many beginner traders concentrate only on potential price movements of the underlying share, while ignoring the impact of changes to implied volatility. This is a mistake and successful option traders understand the nature of implied volatility risk and how it can effect the profitability of their option strategies.
Our goal is to provide you with a sustainable option trading edge through advanced measures of implied volatility, implied volatility percentile, historical volatility, option trade rankings and other volatility skew analysis and trading tools.