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Minimizing Your Risk with Vertical Debit Spreads

Tony Zhang
August 14, 2019
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7 minutes read
Minimizing Your Risk with Vertical Debit Spreads

What are debit spreads?

Placing a trade on the direction of a stock using options typically requires purchasing a call or put option. When purchasing options, the largest headwind is erosion of the extrinsic value of an option over time. This is measured by the option’s theta. For a strategy to be profitable, one must predict both the direction and magnitude of the change correctly in order to overcome the loss due to time decay. One option strategy that allows investors to minimize both their risk and the impact of this time decay factor is a vertical debit spread. A debit spread can be compared to buying a call or put option, but with capped rewards and less risk. This is accomplished by buying an “at-the-money” (ATM) option and writing an “out-of-the-money” (OTM) option. The premium received from writing the OTM option offsets the total cost of buying the ATM option, and the risk is limited to the difference between the cost of the long leg and the income received from the short leg. To learn more about how to implement this strategy, see our recent video entitled Minimizing Your Risk with Debit Vertical Spreads.

Theoretical example – XYZ stock is currently trading @ $100

Chart 1 – Bull Call Spread
Source: OptionsPlay

This strategy compares to risking $4 with unlimited upside when buying only the 2-month $100 call option.

Chart 2: Bear Put Spread

Source: OptionsPlay

This strategy compares to risking $4 with unlimited downside when buying only the 2-month $100 put option.

Debit spread strategy

A vertical debit spread reduces the overall risk of the directional strategy and, furthermore, the short leg reduces the effect of time decay. Lastly, the stock does not need to move as much for the strategy to be profitable when compared to buying only a call or put option. So this strategy provides three additional benefits over buying a simple call or put, while only capping rewards when the stock makes a substantial directional move.

Optimal debit spread

While an optimal debit spread will depend on both one’s risk tolerance and outlook, our research has identified a few best practices for this strategy:

  1. Using expiration dates that are generally more than 5-6 weeks away will reduce the time decay of the long leg.
  2. Buy an option with a delta of 50-60 and write an option with a delta of 10-15. Buying an at-the-money option provides the right balance between having enough upside exposure and risking a relatively small amount of capital. And writing a 10-15 delta option provides a good balance between receiving enough premium to offset the risk of the long leg and having a strike price that is further into the future. This reduces the probability that the strategy’s profits will be capped due to a large directional move.
  3. Using the above parameters, the premium received from the short leg will offset roughly 10%-20% of the premium paid for the long leg.

How to effectively manage debit spreads

As with any options strategy, risk management is key when utilizing debit spreads. Once a large move is expected and a debit spread is initiated, having a planned exit strategy is important for managing both profits and losses. First, if the expected move in the underlying does not materialize, it is essential to exit the trade and cut one’s losses in order to prevent a total loss. Much like when buying calls and puts, debit spreads should generally be exited prior to expiration in order to reduce time decay. A profit target of 75%-100% of the gain on the debit spread serves as a good rule of thumb for taking at least partial profits. In addition, exiting the trade at a 50% loss will mitigate the risk of losing 100% of the premium paid. For example, if a debit spread is purchased for $1 and declines to $0.50, it is best to close the position at a loss. On the other hand, if the debit spread has risen to $1.75-$2.00, this would be an ideal time to exit the trade entirely or take at least partial profits.

Summary

When speculating with options, consider using a vertical debit spread strategy as an alternative to buying a call or put option. Although this strategy may be a bit more complex, it nevertheless provides the benefit of maximizing your returns by simply reducing the risk and capital outlay of each trade. In addition, with the reduced time decay and lower breakeven price, a debit spread will be profitable earlier than an outright call or put.

Learn to deploy this more advanced but flexible strategy in your portfolio using OptionsPlay and our latest webinar entitled Minimizing Your Risk with Debit Vertical Spreads.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The 12th annual Options Education Day in collaboration with the Options Industry Council (OIC) will take place in Toronto on September 14, 2019 at the Westin Harbour Castle. Seats are limited, so sign up before August 19 for the early bird pricing! To learn more: m-x.ca/oed

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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