Transcript Learn to Trade Debit Spreads

Learn to Trade
Vertical Debit Spreads:
The Long and Short
of
Bull-Call & Bear-Put Spreads
Charts provided by: Future Source
© 2004 Field Financial Group
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The Following Presentation Will Cover Various
Aspects of Vertical (Bull-Call / Bear-Put) Debit
Spreads Including:
 What is a Debit Spread?
 How to Identify Entry Points For a Bull-Call Option Spread.
Choosing option strike prices and time-frames.
 How to Identify Entry Points For a Bear-Put Option Spread.
Choosing option strike prices and time-frames.
 When is it Time to Take Profits or Cut Losses?
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What is a Debit Spread?
A debit spread involves simultaneously buying and selling options to create a
spread in which you pay the difference between the premium paid and the premium
collected.
The inverse would be a credit spread which involves simultaneously selling and
buying options to create a spread in which you collect the difference between the
premium collected and the premium paid.
Debit spreads can be a great trading tool to help reduce account volatility as well
as to limit your losses to the amount of the cost of the option spread including any related
transaction costs (commission, fees etc.). The maximum profit potential is limited to the
spread less the premium paid and any related transaction costs. This is why properly
entered debit spreads will incur no margin requirements.
Although, in theory, debit spreads are pretty straightforward, the actual entering
and exiting of debit spreads can be tricky. To reduce potential errors, you should always
“work” your orders as spreads rather than legging in or out. Although legging in or out
can have advantages, it can also lead to potential problems without the guidance of a
licensed broker.
If you need to contact a licensed broker, please call 1-800-800-6304.
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Bull-Call & Bear-Put Spreads
A Bull-Call spread is created by purchasing a call option with a strike price closer to the
actual underlying futures price while at the same time selling a call option with a strike price
further from the underlying futures price. For example, if the December 2004 Coffee futures
were trading at 75 cents/lb (or 75), an example of a Bull-Call spread would be:
Buy one December 2004 Coffee 130 Call Option*
Sell one December 2004 Coffee 150 Call Option*
A Bear-Put spread is created by purchasing a put option with a strike price closer to the
actual underlying futures price while at the same time selling a put option with a strike price
further from the underlying futures price. For example, if the December 2004 Silver futures were
trading at $6.75/oz (or 6.75), an example of a Bear-Put spread would be:
Buy one December 2004 Silver 6.25 Put Option*
Sell one December 2004 Silver 5.75 Put Option*
*Options spreads are examples only. Consult your broker for up-to-date spread information
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How to Identify Entry Points For a Bull-Call Spread
It is very important to do your research before entering a Bull-Call spread. For example,
you must try to identify the potential for a large upward move in the underlying futures contract.
The monthly coffee chart above shows a long-term basing process going back to the end of 2001.
This chart only tells half the story though. It is imperative to look at this contract in multiple time
frames. Since options are a time-wasting asset, entry points into the market can be critical.
Remember, don’t throw everything at the market all at once. Decide the amount of investment
dollars you want to put toward your trade. Put a third or a half into the market now and work better
spread prices on the remainder using good-till-cancelled (GTC) orders. This positions you in the
market in case of a quick break-out with a plan in place to enter the rest of your position if the
market meanders for the next couple of weeks. Also, don’t be afraid to roll your spreads out to other
contract months if the move you anticipate has not yet occurred. With the understanding that there
will be additional transaction costs incurred (commission, fees etc.).
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There is no way to be absolutely certain that a market will perform in any given
manner. While researching a particular market, try to envision what other traders might be
analyzing in order to catch the wave of momentum early. This is important because the cost of
vertical spreads can increase rapidly.
The weekly Coffee chart below shows a 52-week up-trend starting with the low of
55.30 set during the week ending March 21, 2003. The market then bounced to a high of 70.00
during the week ending May 9, 2003. The next significant low was 55.80 for the weeks ending
June 20, 2003 and June 27, 2003. The market soon traded up to a high of 70.75 in the week
ending September 12, 2003. This pattern of higher lows and higher highs typically attracts
bullish sentiment, often signaling a potential break-out scenario above market resistance.
At the end of November 21, 2003, Coffee futures made a higher significant low at
56.40, followed by a sharp rally to 79.20 at the end of January 2004. This higher high gives
further support to a break-out scenario.
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Since the market has traded sideways for the better part of three years, situations
like this may call for a longer-term Bull-Call spread. You need to decide how much you are
willing to pay per spread and how far you think the Coffee market might rally. Based on these
factors, you should be able to identify a spread that meets your requirements. For this example
I have chosen the following:
Buy 1 December Coffee 130 Call
Sell 1 December Coffee 150 Call
125 limit to the buy-side
You must remember that the nominal closing price for these options may not reflect
the actual bid/offer for the spread. You may need to give a few ticks on either side to get your
spread order filled. Work a fair price and if it isn’t filled quickly, widen the bid little by little until
your order gets filled. Remember, never pay too much!
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If you decide to hold your spreads until option expiration and:

KCZ4 settles above 150, your profit would be the total spread value less the premium paid.
$7500 (20 cent spread) - $468.75 (premium paid) = $7,031.25 (1500% profit return per
spread).

KCZ4 settles between 130–150, your profit would be the difference between the settlement price
of the underlying futures contract and 130, less the premium paid. With a 20 cent spread
between strike prices, your potential profit/loss would range between $7,031.25 profit (see
above) per spread to a <$468.75> loss. If the market were to settle at 130 leaving the spread
worthless, you would lose the amount of premium paid.

KCZ4 settles below 130, you would lose the premium paid for the spread. In other words, you
would lose the premium paid for the 130 put and gain the premium you collected for the 150
put, for a premium loss of <$468.75>.
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How to Identify Entry Points For a Bear-Put Spread.
As with Bull-Call spreads, it is very important to do your research before entering a BearPut spread. For example, you must try to identify the potential for a large downward move in the
underlying futures contract. The daily Silver chart below shows a potential failure to break above
recent highs, thus setting up a possible test of the 5.75 area. Since options are a time-wasting
asset, entry points into the market can be critical. Remember, don’t throw everything at the market
all at once. Decide the amount of investment dollars you want to put toward your trade. Put a
third or a half into the market now and work better spread prices on the remainder using good-tillcancelled (GTC) orders. This positions you in the market in case of a quick price slide with a plan
in place to enter the rest of your position if the market meanders for the next couple of weeks.
Also, don’t be afraid to roll your spreads out to other contract months if the move you anticipate
has not yet occurred.
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On February 27, 2004, December Silver futures traded near 6.75. Imagine on this day
you decided to buy a Bear-Put spread with strike prices of 6.25 and 5.75 @ 15 cents limit. Buying
this Bear-Put spread means buying the put with a 6.25 strike and selling the put with a 5.75 strike
paying a net premium of 15 ($750). If December Silver were to break above contract highs, you
may consider exiting this position while there is still time value left on both options.
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If you decide to hold your spreads until option expiration and:
•
SVH4 settles below 5.75, your profit would be the total spread value less the premium paid. $2500
(50 cent spread) - $750 (premium paid) = $1750 (233% profit return per spread).
•
SVH4 settles between 6.25 – 5.75. your profit would be the difference between 6.25 and the
settlement price of the underlying futures contract, less the premium paid. With a 50 cent spread
between strike prices, your potential profit/loss would range between $1750 profit (see above) per
spread to a <$750> loss. If the market were to settle at 6.25, this would leave the spread
worthless, losing the amount of premium paid.
•
SVH4 settles above 6.25, you would lose the premium paid for the spread. In other words, you
would lose the premium paid for the 6.25 put and gain the premium you collected for the 5.75 put,
for a premium loss of <$750>.
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When is it Time to Take Profits or Cut Losses?
This question can only be answered in relation to your personal trading objectives. You
might want to consider purchasing multiple spreads to have the flexibility to exit some and hold
others for a potential bigger move. It is also important to work GTC orders with pre-set profit
objectives in order to exit your positions during periods of high market volatility. Remember, the
volume in certain spreads can be very thin. Working orders can give you a better chance of
having the right price at the right time.
Don’t forget to cancel your remaining GTC orders once you have closed out your positions.
Forgotten GTC orders can lead to unexpected/unwanted positions in your account.
To learn more about these and other opportunities, call 1-800-800-6304 and ask to speak
with a Professionally-Licensed Broker.
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