Many traders are first attracted to options, and first use options, for directional trading. Directional trading is where the trader believes he knows which way a stock, index or future is going and opens an option position to take advantage of the expected move. More often than not, this option position is a simple call or put purchase. However, buying calls and puts is high-octane trading.
Directional traders have a lower octane alternative to simple call and put purchases -- debit spreads. All option traders should consider the benefits of spreading. A spread is constructed by buying an option and selling another option of the same type (call or put) on the same underlying. Usually the two options are of the same expiration month. (Such a spread is said to be a "vertical" spread because the options differ only by strike, and in the array of available options you picture the strikes running vertically.)
When the option bought is more expensive than the option sold, the spread is said to be a "debit" spread because its opening results in a net debit to your trading account. When the option sold is more expensive than the option bought, the spread is a "credit" spread. However, we will only be discussing debit spreads in this article.
How does a debit spread work, and why should you use it?
When you buy a debit spread you are essentially buying the difference, or spread, between the prices of two options. You are expecting that with the right market move that price difference will widen, resulting in a profit.
A trader who buys a debit spread in calls expects the underlying to go up in price. As the underlying goes up both legs (options) of his spread will increase in price, but the option you bought, being closer-to-the-money, increases in price faster than the sold option, thus widening the spread. Conversely a trader buys a debit spread in puts when he expects the underlying to go down in price.
One reason a spread is attractive relative to a simple purchase is the size of position you can afford to own. For example, say the following call options are available (in the same expiration month) for XYZ stock currently trading at $47.50:
With $500 you could only afford to buy 5 calls with a strike price of 50. However, you could afford to enter a 10-lot of a debit spread between the 50 and 52.5 options, as the spread (difference) is currently $0.50.
As when buying an option, you may lose the entire amount paid for a spread and no more. However, unlike buying an option, where the value of your position could theoretically increase without limit, the value of a spread can increase only to the difference in the strikes.
For example, a spread made with the 50 and 52.5 options can only go to a maximum value of $2.50. Buying it now for $0.50, it could either go to 0 (both options out-of-the-money), 2.5 (both options in-the-money), or any price in between (the 50 option in-the-money and the 52.5 option out-of-the-money).
The illustration below displays the performance of a call debit spread in contrast to a simple call purchase with the same amount of capital.
Notice that at expiration, the debit spread is more profitable than the simple call purchase when the stock price ends between $50 and $55.
A spread also behaves very differently over time than a simple option purchase, and because of that, traders must decide if it is appropriate for their psyche. The price of a spread changes very gradually as the price of the underlying moves. Thus it is more sedate, requiring less attention.
Also, a spread has minimum and maximum outcomes. Thus, much like a Las Vegas bet, you either win or lose. The angst of picking a selling price, so important with simple option buying, is abated.
Simple option buying requires greater strength of discipline. A simple call or put position is like raw energy. It responds dramatically to every move in the underlying. Thus the trader must add his own discipline -- objectives, stops, and perhaps trailing stops.
In contrast, spreads allow the trader more time to make an exit decision. Spreads may even be held all the way to expiration without concern over rapid time decay. In fact, if the underlying has made the move you expected, your spread, now in-the-money, makes money with time.
In times of exceptional volatility, when options are more expensive, the option buyer is at a disadvantage. However, the option spreader gets to neutralize this effect by selling an overpriced option at the same time as buying an overpriced option.
One caveat with spreads: if the underlying quickly makes the move you expected, you may be disappointed to see that your spread has not gained much. For the spread to achieve its full potential requires holding the spread to the final day of its life. Not only could this be too boring for your trading psyche, it also risks giving the underlying time to slip back.
Also note that since spread trading involves trading more option contracts with the same capital, it incurs greater commission charges.
Bottom line: For directional trading, use a strategy that best matches your trading psyche. A lot depends on how involved you want to be, or can afford to be, in watching the markets. Your trades need to be interesting – but not anxiety producing. If you find that buying calls and puts is too stressful, consider switching to milder, more casual spread trading. Successful traders are unemotional, unstressed traders.