Q&A
Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics
|
CREDIT AND DEBIT SPREADS
What are some money management tips for credit and debit spreads?
Specifically, when should I get out if a spread goes against me? -Bob
Great question. By purchasing or selling spreads, you've minimized the
risks of stock ownership while maintaining a greater potential return on
investment. However, just because you have taken the measure to place a
spread trade doesn't mean you should just "set it and forget it."
So when exactly is the best time to get out of a spread? Since you asked
for both a debit and credit spread, it requires two different answers:
First, the debit spreads. Since your maximum risk is limited to the
debit of the trade, you can approach your exit strategies from a couple
of angles. You should avoid putting on debit spreads in which you're not
willing to lose the entire amount in the event of a gap opening that moves
against you. That's not a likely situation on every trade, but you should
always consider the worst possible scenario before entering. The trick
is to keep the debit as small as possible while maintaining a high reward-to-risk
ratio. Generally, it's a good idea to set up these trades with the ability
to make at least $2 for every dollar risked, but never less than $1 for
$1. On a spread in which there are $5 between the strikes, that would equate
to a risk of $1.65-2.50. Be careful of risking any more than half the spread.
If you're only trading a couple of spreads at a time, then commissions
are a consideration as well, and can add to the expense of the trade by
as much as $1 in some cases; this makes any kind of profit extremely difficult.
In lieu of a price stop, you should consider using time stops - always
getting out of the trade with at least 30 days to expiration. That way,
should the underlying move against you or not at all, you're out of the
trade with at least some of the time premium saved. The greatest amount
of time decay in an option life is in the last 30 days before expiration,
so it's a good idea to get out before then.
Many traders will use a mental stop-loss to get out of trades. The reason
you can't use a real stop-loss is because most brokers will not accept
stops on spreads. If you're going to use the mental stop, the problems
are twofold: First, if you're only trading a couple of spreads at a time,
then your commissions will represent a significant portion of the total
premium paid for the trade. And second, with most brokers, you will not
be able to enter stop-loss orders on spreads; it creates a cumbersome and
impractical situation for many. You would have to watch the prices of your
options constantly, and might be wiggled out of a trade prematurely. Logically
speaking, you're better off looking for good spreads that cost $1.50 without
the intent to stop out than to buy spreads for $3 with the intent to stop
out at $1.50 (due to the additional cost in commissions).
As far as credit spreads go, should your analysis of the trade be incorrect
and the trade move against you, there's not much you can do other than
roll out of the trade by buying back the spread and selling another one
immediately at the next distant expiration. You could use different strikes,
of course, but essentially, the loss in the first trade is real and the
risk in the second trade could be just as great, should you use different
strikes. One strategy for exiting credit spreads is to buy back the spread
when the cost equals twice the credit.
These days, some of the best credit spreads have been on stocks that
have been beaten up and are trading under $25. There's still a lot of volatility
in some of these issues, so they offer premiums to suck in as a credit.
Optional stocks under $25 have strikes that are $2.50 apart. When trading
credit spreads, you want to take in as much credit as possible while leaving
your exposure to risk at a minimum. Often, you can look for credits as
large as $0.75 to $1 at-the-money?. Since the risk in a credit spread is
equal to the difference between the strikes minus the credit, it's a good
idea to look for trades in which the distance is minimal, so you don't
get caught up in a big reversal in the underlying. Taking in $1 on a 2.5-point
spread is better risk management than the same credit on a five-point spread.
Since credit spreads can be capital-intensive when buying back due to
the bid/ask spread between options coupled with commissions, something
else to consider would be to purchase an additional long position with
the same month and strike as what you have in the spread. Essentially,
what this does is convert the trade into a ratio backspread. Be careful
on something like this if there are fewer than 30 days left in the trade,
however. Putting more capital into such a trade is taking on more risk
than the original position dictated, but can offer nice rewards if the
reversal in the underlying is explosive.
Return to June 2003 Contents
Originally published in the June 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.
