Hedge Investments with Spread Trading

Vertical spreads offer investors the opportunity to profit on an underlying security without owning the stock and leaving themselves open to large risks. Of the many stock investment strategies, there are only four Vertical Spreads: two credit spreads (Bear-Call Credit Spreads and Bull-Put Credit Spreads) and two debit spreads (Bull-Call Debit and Bear-Put Debit). But which spread should you choose?

An investor can eliminate 50% of the choices by determining if they have a bearish or bullish sentiment on the security. If I were bearish on XYZ, I would not look to trade a Bull-Put Credit spread or a Bull Call Debit spread. Conversely, if I were bullish on XYZ, I would not look to trade a Bear-Call Credit spread nor would I look to trade the Bear Put Debit spread. But where do we go from there?

Let’s say I have a bullish sentiment on XYZ…

Bull-Call Debit Spread…
In a Bull-Call debit spread an investor will sell a call and buy a deeper ITM (in-the-money) call for protection. Because the ITM option will cost more, the investor will enter the spread with an initial debit. The profit is obtained when the stock is trading above the higher strike call at expiration and both options are closed for (close to) their intrinsic value.

The max profit is the difference in strike prices minus the net debit.
The max risk is the net debit.

If the stock does go against you and falls below the purchased call strike, then both options will expire worthless and you only lose your initial investement, the net debit. You don’t own the stock, so this is an uncovered position. There is no margin requirement since you paid a debit to get into the position. (If one was bearish on XYZ, they could trade a Bear-Put Debit spread. In this trade the Investor will sell a put and then buy a deeper ITM put. The max profit and max risks are the same as for the Bull-Call Debit spread).

Bull-Put Credit Spread…
In a Bull-Put Credit Spread an investor will sell a put and then buy a deeper OTM (out-of-the-money). Since the sold put is closer to the stock price, this investor will enter this spread for a credit. The profit is obtained when the stock remains above the short put strike price. Both options will then expire worthless and the investor will keep the net credit.

The max profit is the net credit.
The max risk is the difference in strike prices minus the net credit.

If the stock falls below the purchased put strike price, the investor will have to buy shares of stock at the higher put strike, although they can limit the loss by putting the stock to someone at the lower put strike price. No stock is owned so this is an uncovered position. However, most brokerages will require margin for the credit spreads. Typically the margin is equal to the difference in strike prices minus the initial credit received (the max loss value). (If one was bearish on XYZ, they could trade the Bear-Call Credit spread. In this trade the investor sells a call and buys a deeper OTM call. The max profit, max risk, and margin requirements are the same as for the Bull-Put Credit spread).

Strategic Differences…

• For the Debit spreads you want both options to be ITM at expiration.

A safe strategy for the Debit spreads is to make sure the sold option is ATM or slightly ITM. This way, you have a greater probability that the options will remain ITM at expiration.

• For the Credit spreads you want both options to be OTM at expiration.

A safe strategy for the Credit spreads is to make sure the sold option is OTM. This way, you have a greater probability that the options will remain OTM at expiration and they will expire worthless, meaning you keep the entire net credit.

• For Debit spreads, an investor has to actively close the position at or before expiration in order to obtain a profit. This means that an investor will pay a commission to enter the spread, and then pay another commission to close the spread.

• For Credit spreads, an investor simply has to let the options expire if they picked the right direction. An investor will only have to pay the initial entry commission costs with a credit spread.

• Margin is not required for the Debit spreads since the maximum risk is the net debit.

• Margin is required for the Credit spreads since the long option is deeper OTM and does not cover the potential assignment requirements of the short option.

The tools on PowerOptions® will help you find spread trades, analyze them, and determine which is best for you. The site shows the expected return, break even, and probability of success for over 400,000 different spread trades.

The patented SmartSearchXL® tool can scan these combinations to find only those spreads that match your specific criteria.

The PowerOptions OneStrike® tool allows investors to compare all Credit or Debit spread combinations one stock at a time for any expiration month.

PowerOptions is a great set of tools and educational materials to learn options trading.
[tags]hedge investments, vertical spreads, stock investment strategies, stock market tricks[/tags]