For those of you who haven’t seen Phil’s excellent article this weekend on maximizing time, I highly encourage you to invest a little time reading it (it could save you a lot of time later!). Speaking of Phil, I am not quite sure how he manages to juggle five careers (it’s probably eight but I can count at least five) and still produce interesting articles and outstanding results. Well that is until I saw this video on "The Tenth Dimension". It was clear from his article that he has studied Einstein’s work so I am sure in his spare time he expanded upon it and figured out how to operate in a parallel universe to accomplish twice as much!
Well enough of the introductions, let’s get to making money!
Debit Spreads
In recent articles, I discussed the major advancement needed to trade options over and above trading stocks; learning how to be correct in both direction AND time. Applying that concept to spread trades, it is quickly evident that entering bull call or bear put spreads is a low-probability game.
In both spreads you are losing right away due to commissions, slippage and time-decay. You could easily argue that this is also the case when trading long calls or long puts. The difference is that when trading long options, you can easily make up the loss due to commissions or slippage with a small stock movement in the intended direction. With a spread you are immediately at a disadvantage due to the inherent hedging associated with the trade.
In a bull call spread, as the long call makes you money the short call loses you money and, similarly, in a bear put spread, as the long put gains the short put loses. The key aspect to pay attention to when trading bull calls or bear puts is the DIFFERENCE between how much you are making and how much you are losing. Usually the difference is a lot smaller than you might think. This means that as the stock makes a big move, you can often find yourself making very little.
And remember, in order to make this "little" amount of money, you need to be correct in both direction AND time. As a result, these spreads should not comprise a major part of your trading methodology.
Credit Spreads
Credit spreads such as bull puts or bear calls are much more attractive at first glance. In both cases, you can consider that the credit you receive entering the trade pays for the commission costs and, since you expect both options to expire worthless, slippage is not a concern.
The disadvantage of the credit spread is that the reward is usually much lower than the risk incurred. This is somewhat offset by the advantage, however, that the stock does not need to move whatsoever to make money.
So are credit spreads better than debit spreads?
Spread Your Spreads
In order to decide which spread to choose, it’s first best to identify clear expectations. If you are overwhelmingly bullish, a bull call will make more than a bull put in an uptrend. But what if you are wrong? Then the question becomes "what do I believe could happen the stock if the stock does not rise?". If the answer is stay flat or drop a little then why not consider what I call "Spreading Your Spreads".
That simply means that rather than putting your entire bet on the bull call spread, you could enter two partial positions: a bull call spread and a bull put spread.
The bull put produces a credit that offsets some of the debit of the bull call and lowers the loss if the stock stays flat. Meanwhile, if the stock does rise as originally expected, both spreads make money. The profit potential of the bull put would be lower than that of the bull call so you wouldn’t be making as much money as if all your eggs were placed in the bull call spread basket.
One of the aspects of Phil’s article was balance and balancing a more aggressive bull call spread with a much less agressive bull put is often a nice compromise when you do not have 100% conviction in the debit trade alone. A similar compromise can be struck between a bear put and bear call.
Widen The Strikes
With all that said, you will find many who do not like debit spreads because of the limited profit potential and the difficulty making a lot of money even when you are correct. I would certainly echo those concerns, which is why a combination of spreads is quite attractive. Another way of making more money is to widen the strike prices between the long and short options in a debit spread. By so doing, the "difference" mentioned earlier increases and you will make more money as stocks rise with bull calls and you will also make more money as they fall with bear puts.
Addendum
For those of you not overly familiar with the definitions of the debit and credit spreads mentioned above.
Bull Call = Long Call at lower strike price to Short Call in same expiration month
Bear Put = Long Put at higher strike price to Short Put in same expiration month
Bull Put = Short Put at higher strike price to Long Put in same expiration month
Bear Call = Short Call at lower strike price to Long Call in same expiration month
Bull Calls & Bear Puts are Debit Spreads and the most that can be lost is the debit spent entering the position.
Bull Puts and Bear Calls are Credit Spreads and the most that can be made is the credit received entering the position.
