In this week’s Rookie Blog we are going to talk about the Debit Spread. We have had some inquiries from our members on how these trades are made and how to manage them as they progress to their natural conclusion. We will first look at the makeup of the trade and then extoll the virtues of this trade and then discuss what needs to be done when they win and when they lose.
Spread trading in general has a tonne of advantages over trading plain vanilla type options but we will not spend the time in this blog to go over that as it becomes evident with some experience that this is the case. What is important is the structure of the trade and its components because its these components that determine what we need to do to manage the trade between inception and completion.
Spreads typically consist of buying an option and selling one. These can be different expiration dates or be the same which is the case for our debit spread. The prices for the spreads are typically different as well unless you are doing a calendar spread that has the same price and different dates. You may be asking why the prices and dates matter and that is because that’s how the spread is created, we are either spreading prices or time.
The spread becomes important when we refer to the debit spread because it determines the max amount of profit that can be made. The debit spread requires an outlay of capital and has a reward that is typically much higher than the cost of the trade. This trade does require that the stock moves in the desired direction to be profitable. Sideways movement or adverse movement does not work for this trade. Knowing that this trade has to move in the desired direction to be profitable gives us a clue as to how this trade needs to be taken care of while in progress.
Let’s first explore how options work from an obligation standpoint. Options are unique in that they are contracts that have rights and obligations tied to them. If you buy an option then you have the rights that are associated with that contract, you are able to buy stock or sell stock depending on the contract you buy. On the other hand if you sell an option then you are obligated to carry out the parameters of that contract as in you may be forced to buy stock or sell stock according to the terms of the deal. This is the start of explaining what needs to be done when managing the trade but there is one more key to options. At the expiration of the contract there are things that can automatically happen depending on the price of the stock. If an option is in the money at expiration then it will be automatically exercised or assigned. This means that if a long option is in the money then you will be assigned shares at the stike price of the contract. If you are short an option then the shares will be exercised.
Essentially if both options are in the money then the trade will go away with the exercise and assignment. However, if only one option is in the money then the trade must be managed as the out of the money will expire worthless and the in the money option will be exercised or assigned and this may not be a desirable outcome as one may not wish to buy or sell the stock.
Managing the debit spread comes down to where the price lands at expiration. As stated if both options are in the money then the trade takes care of itself. If only one of the options is in the money then the trade must be closed out to prevent the stock from being transferred according to the contract.
There are other considerations at play here. If the price of the stock lands at the short strike before expiration then the max gain at that moment is reached and the trade can be closed if so desired. To reach the actual max gain the price must be at the short strike at expiration, however, because the price movement is dynamic, waiting for the max gain can be an issue if the stock price decides to turn and therefore a good practice is to have a set of rules in place in which one is willing to take profits which requires closing both sides of the trade.
When you compare the debit spread and the credit spread, we want the credit spread to end up out of the money and in the case of the debit spread we want it to end up in the money. As for the debit spread it is paramount that we monitor the trade and take appropriate action when required. The debit spread as with all trades require a solid trade plan before entering the trade. With the potential for exercise and assignment, when building the trade plan this must be a consideration.
Coach “Old Money” Holmes