Use Debit Spreads for better approach!

Most traders are first attracted to options for high-leverage directional trading. Directional trading is where the trader believes he knows which way a stock, index, or future is going and opens an option position to take advantage of the expected move. More often than not, the new options trader starts out simply buying calls or puts. However, buying calls and puts is high-octane trading.

Traders, especially beginning options traders, should consider the benefits of spreads. A spread is constructed by buying an option and selling another option of the same type (call or put) on the same underlying. Usually the two options are of the same expiration month. Such a spread is said to be a vertical spread because the options differ only by strike, and in a matrix of options, you typically picture the strikes running vertically. When the option bought is more expensive than the option sold, the spread is said to be a debit spread because its opening results in a net debit to your trading account. When the option sold is more expensive than the option bought, the spread is a credit spread.

How Does a Debit Spread Work, and Why Use It? When you buy a debit spread, you are essentially buying the difference, or spread, between the two options prices. You are expecting that, with the right market move, the price difference, or spread, will widen, resulting in a profit. A trader who buys a debit spread in calls expects the underlying to go up in price. As the underlying goes up, both legs (options) of his spread will increase in price, but the higher-priced leg will increase faster, thus widening the spread.

Conversely, a trader buys a debit spread in puts when he expects the underlying to go down in price. As the underlying goes down, both legs of the spread will increase in price, but the higher-priced leg will increase faster, thus widening the spread.

As with buying an option, you can only lose the amount paid for a spread and no more. However, unlike buying an option, where the value of your position could theoretically increase without limit, the value of a spread can increase only to the difference in the strikes.

Psychological Factors

A spread behaves very differently than a simple purchase, so trader’s must decide whether spreads are appropriate for their psyche. The price of a spread changes very gradually as the price of the underlying moves. Thus it is more sedate, requiring less attention. Again, a spread has minimum and maximum outcomes. Thus, much like a casino bet, you either win or lose. The angst of picking an exit point, so critical with simple option buying, is abated.

Simple option buying requires great discipline. A simple call or put position is like raw energy. It responds dramatically to every move in the underlying. Therefore, the trader must bring his own discipline into play—using objectives, stops, and perhaps trailing stops.

In contrast, spreads allow the trader more time to make an exit decision. Spreads may even be held all the way to expiration without concern for rapid time decay. In fact, if the underlying has made the move you expected, your spread, now in-the-money, makes money with the passage of time.

In times of exceptional volatility, when options are more expensive, the option buyer is at a disadvantage. However, the spread trader gets to neutralize this effect by selling an overpriced option at the same time he is buying an overpriced option.

One caveat with spreads is that if the underlying quickly makes the move you expected, you may be disappointed to see that your spread has not gained much, and that achieving its full potential requires holding the spread to the final day of its life. Not only could this be too boring for your trading psyche, but it also risks giving the underlying time to slip back

Also note that since spread trading involves trading more option contracts with the same capital. Bottom line: For directional trading, the trader needs to use a strategy that best matches his or her trading psyche. A lot depends on how involved you want to be, or can afford to be, in watching the markets. Your trades should be interesting but not anxiety producing. If you find that buying calls and puts causes you too much emotional stress, you may need to consider switching to milder, more casual spread trading. Successful traders are unemotional, unstressed traders.

Happy Trading!!!

Cheers.