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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.

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2 comments:

  1. Bev, I ran across your blog when I was searching for info on Options Animal. Your comments have been very helpful. Tks.

    I understand what you mean about Debit Spreads, a new strategy that I just learned is to go further of the money and then put on a credit spread for twice as many contracts as the debit spread to use the credit to offset the debit. If the trade moves against you or stays the same you have a zero to almost zero loss. If the trade moves in your favor you can then manage the credit spread. I'm still learning this but something for you think about. I'm seriously considering joining Options Animal. The person that taught me this called an unbalanced Condor. I also have Darlyn's DVD's.

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  2. Hi Clyde! Oh, this is exciting! I've never heard of this, and can't wait to think it through and give it a try! I'll write about it, if I can figure out
    exactly how to do it. Thanks for sharing. I really love learning new things about this stuff. (sometimes I feel like an unbalanced condor. :-) )

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