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

Going vertical with debit spreads

Upside opportunity

The cost and the profit potential of the trade are dependent on a couple of factors. The strike price of the long call option is probably the biggest contributor. If the long option is OTM, the price will be cheaper than an ATM or ITM option. The lower cost of the long option means the spread’s cost is lower, which in turn means more maximum profit potential.

The disadvantage of buying the option farther OTM is that the underlying stock has to change in price more to reach the maximum profit potential. The closer the long option strike is to being ATM, or further ITM, the more expensive the spread will be. ATM or ITM options always are going to be more expensive than OTM options. If ATM or ITM options are bought, the spread will be more expensive, which lowers the maximum profit potential. On the plus side, however, the underlying stock will have to move less to reach maximum profit and surpass the sold option’s strike by expiration.

Another factor is the distance between the long and short strikes. If a shorter distance is chosen, usually the spread will cost less because the short strike will have a higher premium. Also, the stock will have to move less to reach its maximum potential because there is less distance between the strikes. If a larger distance is chosen between the strikes for a vertical debit spread, the spread will cost more; the short strike premium will be less because it is farther away from the long strike. The stock now will have to move more to reach its maximum potential, but that maximum profit will be greater, as well, because of the bigger spread between the strikes.

Bullish scenario

A bull call spread (bullish vertical debit spread) involves buying a call option and selling a higher strike call option. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The most the option trader can lose is the cost of the spread.

It’s Oct. 28 and YYY stock is trading at $94.15 per share. An option trader believes that within two months, the stock will be trading at $100 per share and might stall out there. One strategy would be a bull call spread. The trader could buy the December 95 call (a near-the-money call) with a current delta of 0.49 for $6.40 and sell the OTM December 100 call with a current delta of 0.34 for $4.40. The cost of the spread is $2 ($6.40 - $4.40). This is the most the trader can lose if the stock finishes below $95 by December expiration (see "Bull call debit spread," below).

The maximum profit potential on the trade is $3 ($5 - $2), which is the difference in the strikes minus the cost of the trade. The maximum profit would be achieved if YYY finished above $100 at December expiration. Breakeven on this trade can be calculated by adding the cost of the trade to the long call’s strike price. In this example, it’s $97 ($95 + $2) at December expiration. If the December 95 call were bought on its own, the breakeven on the trade would be $101.40 ($95 + $6.40).

Currently, the delta on the spread is 0.15 (0.49 – 0.34), which means the trade will make or lose 15¢ for every dollar the stock goes up or down. Initially, it can be a disadvantage, but if the stock declines, the trader will lose less on the spread than by just being long the calls. As the options get closer to expiration, the delta on the spread will widen. However, the goal of the trade remains the same: For the stock to trade over the sold call’s strike by December expiration.

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