When to Use a Debit Spread Option Trade

06/23/2010 12:01 am EST

Focus: OPTIONS

As a directional trader, I trade the way the market tells me it wants to go. However, I often get overexposed to one side, leaning too hard, and then have difficulty locking in the best profits when something adverse occurs. But there is a nifty way to lock down some profits and/or limit risk. When putting on a directional trade that goes in my favor, I like to assess the situation, but always have a plan in place. That could change in the middle of the trade of course, which is following good trade management. In the assessment, I need to decide whether to exit the trade, roll to another strike, lock in some premium, or just do nothing. 

It certainly depends on the situation, but when I have a profitable trade that I want to continue, I will often sell an upside call or buy a protective put (creating a strangle). I usually prefer selling the upside call and creating a vertical debit spread (in the case of a put, it would be selling a downside put). Why is this a good play? In an uncertain environment, this provides certainty, and when I want to stay in the game, this gives the opportunity. So, in my Grandslam service last week, we bought some calls July 75 calls on Visa (V), and they performed nicely. We held the trade into the new week, and then on Monday, the stock exploded higher along with Mastercard (MA) (see chart below). 


Click to Enlarge

Our calls were up something like 120% in minutes. News was obviously driving the trade, so I had to think fast and make a move. Volatility was exploding higher on the options, so selling was a good option, but do we exit altogether or sell a higher strike and stay in the game? I chose the latter and sold the 85 call for a nice premium of 2.37 while the stock was at $83, or up nearly 8% on the session. Combined with our purchase at 3.94 on the 75 call, our downside is now 1.57, while our upside is 10 (difference of the two strikes). This equates to a fantastic 6.37 reward/risk ratio. So, if the stock lands on $85 at the July expiration, then our 75 call would be worth 10 (154% return) and we would keep the premium that we sold on the $85 call—a big win/win scenario. 

This is an excellent strategy to lock in premium and winners, but remember, you still have market risk, and this is not a slam dunk. However, repeating this over and over will garner fantastic gains for your portfolio.

By Bob Lang of BigTrends.com

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