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 Click anywhere on the screen to continue
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? Click anywhere on the screen to continue
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 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 -6304. Click anywhere on the screen to continue
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 Click anywhere on the screen to continue
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. ). Click anywhere on the screen to continue
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. Click anywhere on the screen to continue
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! Click anywhere on the screen to continue
If you decide to hold your spreads until option expiration and: § KCZ 4 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). § KCZ 4 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. § KCZ 4 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>. Click anywhere on the screen to continue
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 Bear. Put 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-till-cancelled (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. Click anywhere on the screen to continue
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. Click anywhere on the screen to continue
If you decide to hold your spreads until option expiration and: • SVH 4 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). • SVH 4 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. • SVH 4 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>. Click anywhere on the screen to continue
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 -6304 and ask to speak with a Professionally-Licensed Broker. Click anywhere on the screen to continue
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