Scribd
Upload
10 views

Lecture Master Debit Spreads

Uploaded by

mariadnarp
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
10 views

Lecture Master Debit Spreads

Uploaded by

mariadnarp
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 11

ITM DEBIT SPREADS

Joseph R. Stadelnikas, M.D., M.B.A.


10/6/2011, revised 9/15/2015, revised 2017

Many traders post that they looked at certain stocks and their
technical analysis (and they are passionate about their skills using
TA) shows stock is poised for an up price movement. Ok, buy the
stock. What is your reward/risk ratio?

Options traders looking to take advantage of a possible up stock price


while managing risk, may want to consider a spread strategy: the bull
call debit spread. This strategy involves buying one call option while
simultaneously selling another. Let’s take a closer look at an
example.

What is a Debit Call Spread?


Debit Spreads for Growth and Income
Buy an In-The-Money Call (ITM)
What
Sell an At-the-Money Call is a Debit Spread?
or Out-the-Money Call (ATM/OTM)
Same Expiration Criteria for Initial Set-Up
Growth and Income
Income
Exit Criteria
Taking Profits
Minimizing Losses
Buying In-the-Money and Selling At or Out-of-the-Money debit
spreads is a neutral to bullish outlook strategy. You want to buy an
ITM option to create a "stock substitute" position.

Criteria for Initial Set-Up

Buy ITM Call – Delta ∆ ~ > 70

Growth and Income Investor


Sell OTM Call
Income Investor (Conservative Approach)
Sell ATM Call

SC Premium/LC Premium > 25%; LC > 25% Discount


Time Value: TV Short Call > Ask TV Long Call
IWM at close 8/25/17 was at $136.88

If you bought 1000 shares the cost would be $136,880.

BTO, 29 Sept, $132 Call, 10 contracts


Delta = 0.79
Premium = $5.91 (Bid $5.79, Ask $5.91)

Those 10 option contracts control the same 1000 shares for just 4.3%
of the cost of actually purchasing the stock.

($5.91 / $136.88 = 4.3%).

Long Call

Intrinsic value of $4.88


Extrinsic value of $1.03 (the ask-time value).
If the stock fails to move up, you would lose the $1.03

Depending if you are a conservative or an aggressive trader, you


want to select a short call strike to offset the cost of your long call.

Conservative approach.

Short Call Strike Premium > Long Call Ask-Time Value

STO, $137 ATM Call for $2.33. (> $1.03)

The Net Investment is the Net Debit (difference in premiums).

Net Debit on the trade is now $5.91 minus $2.33 = $3.58.

Maximum Profit is equal to the difference in the strike prices minus


the net debit.

$137 minus $132 minus $3.58 = $1.42


The maximum profit is realized if the stock is anywhere above the
higher strike price, short call strike price, $137

Maximum Risk is the Net Debit (difference in premiums). $3.58

Maximum % Return (Difference in strikes - Net Debit) ÷ Net Debit


=

If the stock increases to the short call strike price, percent return
would, $1.42/$3.58 = 39.7%. ~ 40%

The main downside of a debit spread is that you put a cap on your
upside.

If the stock is flat, no change from current price of $136.88, your net
debit is $3.58 and long call would be worth ($136.88 - $132.00) =
$4.88. You gained $1.30. ($4.88 - $3.58)

Percent return, for no gain in stock, is $1.30/$3.58 = 36.3%.

The Breakeven Price in bull call spreads is the long call strike price
plus the net debit. A profit is realized at any price above the break
even price.

Breakeven with a debit call spread is the long call strike price + net
debit = $132 + $3.58 = $135.58. (vs. stock purchase = $136.88)

Delta (∆) LC = 79 > 70


Premiums SC / LC = $2.33/$5.91 = 39%; > 25%
Short Call Time Value > Long Call Ask Time Value; ($2.33 > $1.03)
SC Time Value = $2.33
LC Time Value = ($132 + $5.91) - $136.88 = $1.03

Trade Set-Up: Criteria Met


PROFIT / LOSS CHART OF TRADE
With a debit-spread strategy, you reduced the cost of the ITM call
option you purchased and limited your risk. We have capped our
upside, but still maintain very favorable returns, if outlook on stock is
correct.

Taking profits on debit spreads is important, as well as a trailing


stop-loss to manage risk.

Initial trailing stop-loss: 50% of max profit.


Trailing-Stop

My approach has been to close half of the contracts, if calculated


unrealized return has reached 50% of max profit.

Taking the example above: let's say we opened 10 contracts. Total


cost is $3580, max profit is $1420, 40% return.

So how would I take profit? When unrealized profit in trade is $710


(50% max profit), close 5 contracts. Realized profit captured is
$355 (cost $1790) or 20% return.

Reset trailing stop-loss to breakeven on the remaining 5


contracts. If your trailing stop-loss is triggered, your return on first
half of position was 20% and return on second half was 0% for an
average of 10% return. Not bad for one-month trade.

The initial trailing stop-loss to close position, should your outlook


be incorrect, is half of the capped % max return.

In example, the max return is capped at 40%. Set the trailing stop
at 20% or $710. Your initial R-Multiple is 2R. Realizing 20% return
on first half and potential 40% return on remaining half, the reward-to-
risk is 30% for an adjusted R-Multiple of 30%/20% or 1.5R.

Stock increases to $138.85, position value increased to $710.


BTC SC and STC LC, 5 contracts, half of position.
Profit realized = $355 or 20%

Remaining position:

Trailing Stop-Loss reset to breakeven: remaining position =


$0.00

If triggered: Initial half of position had realized profit of $355


net investment = $3580 for 10% return
If trailing stop-loss, reset, not triggered: 9/29/17 expiration,

At expiration, stock >= $137 short call strike

At expiration, stock = initial price $136.88

If initial trailing stop-loss never triggered, profit determined by


stock price above your breakeven of $135.58.

At time of trade, if initial trailing stop-loss is triggered, max loss =


$710, midway to expiration ~ 2.7% decline stock price, remember,
your analysis, charts signaled increase in price. Admit you were
wrong.
Learning to Win by Learning to Lose
Initial Trailing Stop-Loss Triggered: Loss

Continued below,

POSSIBLE OUTCOMES

Initial Stop-Loss = 50% of $ Max Profit


% Max Return = 40%, $ Max Profit = $1420
Net Debit (ND) = $3580
Stop-Loss = $710

Stop-Loss Triggered = $710 Loss

$ Max Loss = 50% * $ Max Profit


~ 50% * $1420 ~ $710

Close 50% of Position at Half of Max Profit = 5 Contracts

$355 Profit Realized


20% Max Return Realized ($355/$1790)

Stop-Loss Reset to Breakeven

Stop-Loss Triggered
$355 Profit First Half
$0 Profit Second Half
10% Max Return Realized ($355/$3580)

If Second Half Expires


$355 Profit Realized on First Half
$710 Profit Realized on Second Half
30% Max Return Realized = $1065
Continued below,

The initial trailing stop to close position, should your


outlook be incorrect, is half of the capped % max return. In
example, the max return is capped at 40% return. Your
trailing stop at 20% return. Your initial R-Multiple was 2R.
Taking 20% return on first half and 40% return on remaining
half, 30% return, the reward-to-risk is adjusted R-Multiple of
1.5R

Revised: 2017

End

You might also like