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Friday, May 11, 2012

Vertical Debit Spreads - the Pitfalls

As mentioned at the bottom of my previous post,thanks to Kris Maynard, debit spreads do have some drawbacks: Too often when these spreads are taught (or you read a lesson online), the pitfalls of a strategy are not STRESSED.

I want to be sure that new traders understand that in order for a vertical debit trade to be successful,

1. THE TRADE HAS TO MOVE DIRECTIONALLY (VERY BULLISH or VERY BEARISH) to make a profit. If the stock remains stagnant or moves only slightly in the direction you need, by expiration, you will have a loser.

2. In order for your expectations on the stock price to materialize, and your long call to go in the money, you need to be sure that you have bought out far enough in time for that movement to happen, so TIMING becomes important.

3.You need to look at your charts and determine just how fast/or slow that stock takes to move that much, so the MOMENTUM becomes an issue. Which means you better know your stock's volatility pretty well.

As an example:

You might hear on TV that Amazon stock is doing wonderfully, and decide "oh, I think I'll do a Call on Amazon!" But then you remember that you have lost a LOT of money doing calls, and decide instead to do a Bull Call spread. Meaning that you'll buy your Call, but ALSO sell a call at a higher strike price in order to reduce the cost of that call, since the cost is your total Risk amount. Thus reducing your risk.

So, if we look at a chart of Amazon, you can see that it has indeed gone up. In fact it GAPPED up almost $30 on April 26, 2012. If you wanted to buy the $230 call and sell the $235 call, (see chart below), do you think you have a good grasp of the three pitfalls? Is that trade really going to be very bullish or is it going to "fill the gap" and go down shortly? Do you have enough information to time it properly? And we already know the stock is capable of big jumps, but is it just an event that made Amazon gap up, or does it do this regularly and why?

The point I'm making here is two-fold. Some people feel that debit trades are "safer" because (unlike credit trades) there's no option requirements by the broker, and the risk is only the cost of the net options (Long call minus short call premium). And I want to remind you that a losing trade is not safer by any standards.

The other point is that you really need a Watch List of stocks that you follow diligently. To trade unknowns is asking for trouble. When you trade the same stocks day in and day out, CHANGING YOUR STRATEGIES, depending on the trends, you will undoubtedly have more success than if you just use the same strategy and go out looking at any old stock that might fit the pattern you're after. That's like throwing darts at the stocks and having no knowledge of their fundamentals and historic technicals. It really does help to avoid pitfalls if you KNOW the stocks you're trading.

And it really helps to know the pitfalls of whatever strategies you're using as well.


Sunday, May 6, 2012

Debit Spreads - ROI (Return on Investment Calculation)

One of the things you often read when studying Options is that an acceptable exit from the trade is to predetermine the percentage you would like to make on your investment. Otherwise referred to as R.O.I.


When I first heard about R.O.I., I thought to myself: Hey, I'm a beginner. I'm not looking to find out high faluting information on my profits just now. I'd just like to learn how to trade! And so I didn't pay much attention until I noticed that OptionsAnimal included such calculations on ALL of their lessons where R.O.I.was the primary exit strategy on the trade. And it was included because it was important and an integral part of the trade.

One good reason for it is the discipline to keep your trading a business and not a gambling event. If you are willing to limit your profit to a percentage, and then close the trade at that limit, you will also control your greed. (Don't forget that Fear and Greed are the trader's biggest enemies, and the very things that will/can do you in if you don't plan in advance.>

Then I discovered that it's not ONLY an exit strategy that all spread traders need to know, but that it's a calculation done in advance of the trade TO DETERMINE WHETHER YOU SHOULD EVEN BE IN THE TRADE! In other words, if you like to make (for sake of discussion) 50% profits on your trades, can your underlying equity move enough to even get you to the desired return on your investment? You won't know unless you do the math. Most conservative traders shoot for 25% to 35%, by the way. Oink oink here! I, of course, thought of 50%. But it's your business, make it what you like. But do the math!


What Return Do You Want?

1. Decide what return% you would like on your investment. For the sake of a lesson, let's say 25% would be enough to keep you happy. (that's a lot more than the banks are paying, right?)

What Trade Do You Want?

2. So, you decide on a trade. Let's say we think that IBM is going to go up, and we would like to put on a Bull Call vertical debit trade. So after looking at the chart and the fundamentals, you are fairly certain this stock is going to go UP. So you pull up an option chain and look for the premium it will cost you to do a spread.

The stock is currently selling for $200 per share. So we plan to buy a LONG Call (Buy to Open) (our primary instrument) at the Strike Price of $205 for $4.05.

We plan to sell a SHORT Call (Sell to Open)(our secondary instrument that reduces our cost) at the Strike Price of $210 for $1.97.

So, our investment in this spread is $4.05 minus the credit we get from the sale of $1.97 which equals $2.08 Investment. That is how much I will pay for this spread. It is my total maximum loss amount as well. It represents the cost for one contract which means that $2.08 x 100 shares (per contract) that I will have $208. taken out of my fund when I pull the trigger on this trade.

How Much Does My Spread Have to Be Worth To Win?

3. If we want to make 25% on this trade, ($.25-a quarter-for every dollar we put into it,) then add 100% to 25% and you get $1.25 as your multiplier. Always just add 1 in front of your desired ROI.

We are planning on spending $2.08 on the spread, right? So multiply $2.08 times $1.25 and you get $2.60. So that is what our spread needs to be worth at the time we reverse the trade. It will be our Net Credit after Selling to Close the Long Call, and Buying to Close the Short Call. $2.60.

Check my Math: Investment: $2.08 x ROI desired 25% = $.52 profit. Add profit to cost basis (which you want back too!) $.52 plus $2.08 and you get $2.60. In other words 52 cents represents 25% of our investment. In this trade, we want to get back our $2.08 plus $.52; that figure to reach is $2.60.

If you look at the Option Chain at the time of the trade, you can see that this spread is already depreciated. We paid $2.08 but if we reversed the trade right this minute, we would only get $1.93. Sell to Close the Long Call for $3.95 less Buy to Close the Short Call for $2.02. The difference is $1.93.

So this tells us that we need our option spread to increase in value from $1.93 all the way to our ROI figure of $2.60. The option spread has to increase in value by $.67 cents.

Well, do we just sit here and wonder if it will, and how it will or do we figure out how this thing works?

HOW MUCH DOES THE STOCK HAVE TO MOVE FOR MY OPTION TO MAKE MY ROI? Isn't this the real question? How do we know if this stock will cause that option spread to reach our goals?

The answer is another calculation. (Nobody told you that option trading was easy, did they?)

You probably know that DELTA is what tells you how much the option moves versus every dollar the stock moves. And both your long and short calls have Delta. The Long Call delta is positive, and the Short Call delta is negative. So let's take a look at that.


Trade Monster has neat option chains where you can configure the columns any way you want. So I'm using their chain to show the Delta on this trade. Remember that the SHORT is negative delta, so we will subtract it from the LONG to get our Net Position Delta:

So this shows us that our spread will move .18 cents for every dollar that the stock moves. In order for our spread to increase by .67 cents before expiration, we divide .67 by .18 = 3.72. Therefore, the stock has to go up $3.72 in order for us to reach our R.O.I.

Does this stock move that far? Does it move fast enough to make this much by expiration? Look at the Historical price quotes and your Chart to see just how fast it does move.

If the answer is Yes, then let's do it! Not really. I think IBM's going down. :-)

## Disclaimer: Everything in this blog related to options is for educational (hopefully) purposes only and is NOT any kind of trading advice or recommendations.

Thursday, May 3, 2012

Debit Spreads vs. Credit Spreads - Vertically speaking

I finally had another big Aha! in Options Trading.

It takes SO long to learn this stuff, as in knowing it right off the top of the head. At least it does so for me.

I've pretty much got the Credit Spreads down pat, but then I began to ponder the Debit Spreads. Mind you, these are Vertical spreads with the same expiration months. (I'm not ready to tackle Calendar spreads in depth just yet).

I couldn't quite figure out WHY you would want to do a Debit spread (instead of a credit spread) when it

1. costs money to do so, and

2 you need to buy out in time (theta works against Debit spreads)

3. then you have that wait for things to happen. (depending how far out your expiration).

Whereas Credit spreads are wham bam~! One week or one month and it's all over, and you've got the money in your pocket to begin with.

So what's the point? Why would I use one and not the other? Why doesn't anyone ever compare them?

So I had a pow wow with one of my trading divas today, Linda, and she's very smart and we got into it and figured it out. I learned a lot out of the session and I want to share what I learned. (it probably isn't the whole of it, but it's a start).

It makes the whole picture SO much simpler if you just compare them. In both trades you buy one option and sell another.


Primary Instrument: (option) The Short Call or Put

Secondary (insurance) The Long Call or Put

The Short is sold out of the money,(OTM)the Long is bought further out of the money,(OTM) thus the premium for the Short is in excess of the cost of the Long, so you pocket the difference. A credit in your account when you put on the trade.

Maximum Gain: The credit in your account when you put on the trade.

Maximum Loss: (The Strike Price of the Short ) minus (The Strike Price of the Long) less the Credit in your account when you put on the trade. (the broker holds this maximum loss as margin until the trade is over).

Expiration choices: Theta works in favor of Short instruments, so the shorter time, the better. Weekly or Near Month are the best.



Primary Instrument : The Long Call or Put

Secondary (insurance) The Short Call or Put

The Long is sold at the money,(ATM),even in the money,(ITM) and the Short is bought one level away out of the money, thus the premium for the Long is in excess of the cost of the Short, so you PAY the difference. You are charged for the difference in premiums.

Maximum Gain: (The Strike Price of the Long) minus (The Strike Price of the Short) less the Cost of the debit to your account when you put on the trade. (there is nothing held by the broker for margin).

Maximum Loss: The debit taken from your account when you put on the trade.

Expiration choices: Theta works against Long instruments, so the longer the time, the better. Minimum of 45 days to 90 days is best. (you do not have to hold the trade that long, but that will keep Theta at bay until the last 30 days.)


You will notice that things work in reverse between these two trades.

But take a closer look at a comparison of the Maximum Gain. You can earn MORE with Debit trades. It just takes longer.

Take a look at the Maximum Loss: The losses are HIGHER with Credit trades if they go wrong.

So, it would appear that debit trades make more sense than credit trades, but do they?

Not at all.

Would you like to take a chance on Priceline (PCLN) with a trade that didn't expire until July? The world could blow up (or down) with that crazy stock in that time. But it pays great premium and has a lot of action. There's money to be made there.

Whereas a steady stock like Intel (INTC) with its gradual uptrend for many months might be a perfect candidate for a debit trade that ended in July.

I would rather do a weekly credit trade on PCLN, grab my money and run, and do a debit trade on INTC and make more, risk less, and sleep well over the long weeks it takes to get there.In other words, there's a use for both trades, depending on the stock and your expectations of it.

As I said, I have a lot more to learn, but at least this question is now much clearer. Why on earth would I want to use a debit spread in some cases instead of a credit spread? Well, isn't it obvious?

If not, send me questions, please. I learn by answering them.

PS. My mentor Kris Maynard, upon reading this post, added this very important information: I would only add one little, but important, item: In a debit trade one must be correct about three things - the trend of the underlying; the timing, and the magnitude of the move. A credit trade, I find, is a bit more forgiving in that you can make money in a stagnant market. Positioned properly, one can even make money if the trend goes against the trade. This is why I much prefer credit trades. ##

Tuesday, May 1, 2012

4/27/12 Weekly Trade results

Okay, here's the final results on last weeks credit spreads. I've republished the originals below to see the ones that were not successful. It is VERY difficult to adjust weekly trades, so I have made attempts here to roll said losers into montly trades. Not at all sure it will work, and the WEEKLY trade status makes it very, very much more difficult. But we shall see.
Week 3 was too crazy. I made monthly trades and didn't touch the weeklies. But I'm back, (and a little late posting). Here's my 4/27/12 Weeklies. (note that one of them (BIDU) is already failed; I adjusted it to monthlies which IF they succeed will reduce my losses to $49.50.
If you are looking at the schedule, I.C. stands for "iron condor" which I've placed on Apple. It simply means a Bull Put and a Bear Call put on at the same time (thus reducing fees). ##