From the December 01, 2011 issue of Futures Magazine • Subscribe!

Going vertical with debit spreads

Credit spread strategies have a strong following for obvious reasons. A main component of option premium is time, and option traders would rather have time on their side. Indeed, credit spreads are constructed to take greater advantage of this time decay. In addition, credit spreads may be designed to have a high probability of success. However, with the high probability comes a relatively low reward compared to the significantly higher maximum loss potential.

Credit spreads involve selling the higher-priced option and buying the cheaper option for protection. This has the psychological advantage of starting off net-positive in terms of premium. Debit spreads involve buying the higher-priced option and selling the cheaper option. The most that can be lost on the debit spread is the amount that was paid. Because of this reason, debit spreads are considered to be a more conservative strategy vs. a credit spread.

Here, we’ll take a closer look at bullish and bearish vertical debit spreads. For these spreads to profit, the underlying stock will have to gain or lose value accordingly, making vertical debit spreads a directional strategy.

Pros & cons

The first advantage of a vertical debit spread is cost. It is less expensive than buying in-the-money (ITM), at-the-money (ATM) or just slightly out-of-the-money (OTM) options.

This advantage is all too clear, especially for expensive options with high implied volatility that usually accompany high-priced stocks. Google (GOOG) is a relatively high-priced stock by most traders’ standards, and the options can be very expensive as well. If a vertical spread is implemented in which options are both bought and sold, the cost of the trade can be reduced dramatically.

The stocks and options don’t necessarily have to be expensive to use a vertical debit spread. The benefits can be utilized for cheaper stocks and options as well.

A disadvantage of lowering the cost with a vertical debit spread is that maximum profit is defined and capped. With long options, maximum profit is theoretically unlimited. With a vertical debit spread, the maximum profit is capped by the option that was sold. No matter how much the stock moves past the sold strike, the option buyer most likely will exercise the right to buy or sell the stock at the strike price, negating further gains.

Another advantage of a vertical debit spread is that if the underlying stock moves counter to the position, the spread will lose less than a straight call or put because of a smaller delta and initial costs.

The trade’s delta is smaller because the positive larger delta of the long option is offset partially by the smaller negative delta of the short option. For example, say XYZ stock is trading at $40 a share, and an option trader purchases an ATM call option (40) with a delta of 0.50. For every dollar XYZ goes up or down, the call option should increase or decrease by 50¢. If a vertical spread were created by selling a call with a strike price of 45 and delta of 0.20, the delta for the spread would now be 0.30 (0.50 - 0.20). Now the spread would gain or lose 30¢ for every dollar the stock went up or down.

Delta will increase the closer the options get to expiration. The more an option is ITM, the larger the delta will be. Of course, the downside to lowering the overall delta is obvious. If the trader is correct on the movement and the stock never hesitates, more profit could be made just by being long the option.

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