Why Debit Spreads Beat Simple Long Options Positions - YouTube

why debit spreads beat simple long options positions before we explore why

debit spreads beat simple long options positions by way of preamble let's spend

a few moments explaining what a debit spread is for anyone new to options

trading debit spreads are an option strategy which have been given this name

for a number of reasons firstly because to create them a debit is applied to

your brokerage account they are called spreads because they comprise a

combination of long and short that is bought and sold options positions with

different strike prices the difference in these options strike prices is called

the spread option spreads have two or more strike prices in them each single

position is usually called a leg debit spreads are also called vertical spreads

a vertical spread consists of an equal number of long and short positions but

with different strike prices to be a debit spread the bought leg of the

spread must be closer to the current market price of the underlying stock

than the sold leg putting it another way the long position is closer to the money

than the short position the short leg of this strategy will realize a credit to

your brokerage account which will offset the cost of the bought or long options

that you have purchased the overall effect will be a debit hence the name

debit spread vertical debit spreads involving call options are known as bull

call spreads while those involving put options are bear put spreads okay so now

that we are clear about what a debit spread is let's examine

debit spreads risk reward and strategy unlike simple long option positions

where your potential profit is theoretically unlimited vertical spreads

have limited profit potential but we aim to demonstrate that they also involve

less risk and managing risk is the key to successfully trading the financial

markets the maximum profit is the difference between the strike prices

less the initial debit but there are some serious advantages with debit

spreads over simple long options one you lower your overall risk because

the short position will offset the long one too you control the same number of

underlying shares but for a less cost three you reduce your exposure to

options time decay for you can give yourself more time to be right without

it costing a lot more five sometimes the implied volatility component of options

pricing can work in your favor before you enter a debit spread your policy

should be to pay not more than 50% of the difference between the long and

short strike prices so if you're doing a five dollar spread you should pay no

more than two dollars and fifty cents for it for a two dollars and fifty cents

spread no more than one dollar and twenty five cents and so forth in other

words you would like to see at least one hundred percent profit potential before

entering the trade your two dollars and fifty cents should have the potential at

option expiration date to return five dollar profit and so on here's an

example Exxon Mobil is currently trading at $80 per share your analysis leads you

to believe that it's future price direction will improve to an estimated

87 dollars so you decide to enter a bull call debit spread by buying $80 call

options and selling the same number of $85 call options thus creating a $5

spread looking at our option chain we can see that to buy an $80 call will

cost two dollars and five cents while the out-of-the-money $85 calls can be

sold for forty five cents having offset one against the other we realize that we

can create our debit spread for a net cost of one dollar and sixty cents with

74 days to expiration you'll note that the cost of this spread

compared to the difference in strike prices is less than half one dollar and

sixty cents being much lower than half the $5 difference so it's a good deal

if between now and expiration date the share price advances upwards your $80

long call option will increase in value and the deeper in the money it goes the

Delta component in the options pricing formula will also increase so that the

option price will eventually move at close to a one to one relationship with

the underlying share price meanwhile the out of the money short sold option price

will also increase but at a much slower rate since its Delta is much lower and

until it hits at the money status it's only real value is time value which is

the calculated probability that it will be in the money at expiration date so

the difference in the rate at which the two option prices respond to upward

movements in the underlying stock price is where your debit spread makes an

overall profit if you let it run until expiration date and the stock price is

above $85 you make three hundred thirteen percent profit on the trade

being the five dollar spread divided by the one dollar and sixty

cents cost times 100 if you had only purchased the 80 dollar calls for two

dollars and five cents then at $85 share price you would still make two hundred

forty-four percent profit at expiration being five dollars divided by two

dollars and five cents but three hundred thirteen percent using the debit spread

is much better if the price had gone to $87.50

then you'd make 366 percent profit on the single option but as we can see you

need the underlying share price to move upwards by another 2 dollars and 50

cents for only slightly more profit and why should you risk that now let's look

at debit spreads money management and averaging profiting from option trading

involves the important issue of money management it's all about risk and

reward the amount of your overall capital that you risk versus the

potential reward on each trade the preferable result is for the underlying

financial instrument to move in your anticipated direction and you take a

profit but what if price action goes against you debit spreads cost much less

than simple long positions so if the underlying price action goes against you

and you have factored in more than 100% potential profit on each trade and your

strategy is to hold your positions until expiration date then one possibility is

to consider averaging up if it's a put spread

or averaging down for Coll debit spreads as a way of potentially realizing an

overall profit bearing in mind that debit spreads reduce the effect of

option time decay so that you can choose later expiration months for much less

cost than buying single options and knowing that your maximum loss is 100%

on the cost of any one trade you can use the profit from your second trade to

offset any losses from the first one so if for example you made 313 percent

profit on your second trade on the same underlying stock but lost up to 100% on

your initial trade then your overall average profit is still 213 percent

assuming that the capital risk on each trade was the same you could use

Fibonacci extension levels to determine your second entry point here's an

alternative strategy if the price action goes against you then you can also

consider buying back your original short position as it goes further out of the

money the short leg of the debit spread becomes much cheaper eventually you can

buy it back for pennies making a theoretical profit on the short side if

the stock price then pulls back to somewhere close to where you entered the

original debit spread then you might be able to sell the remaining long leg for

a similar price to what you bought it for the profit on your clothes short

position becomes your overall profit or at least will offset any loss on the

long leg of the spread sometimes you can make a great overall profit this way

combine this strategy with averaging and you increase your likelihood of success

even further thank you for watching please like and subscribe for more -

Debit Spreads vs Credit Spreads