November 20, 2010

Pls explain in laymans terms the following online example of Option debit spread strategy,What's the downside?

By Planet Wealth

Option debit spreads can be a very useful and in some cases, lifesaving tool when trading.

The following example shows how that, even when the price of the underlying financial instrument goes against you, you can still make a nice profit on your investment.
It just takes a bit longer, but it illustrates the superiority of this strategy over only ‘going long’ on call or place options.

The following example was traded on the Australian market, but the principles can apply to any market in the world.

In late August, I entered an option trade on ANZ bank. It was a ‘debit spread’ which is where you BUY a call option (in this case) at a ’strike price’ just above the current market price,
but also SELL another call option at a ’strike price’ higher up. In this case, it was an .50 / .00 spread.
On reflection, it was a terrible time to buy, but I had it pre-set in my broker account to automatically enter at a certain price and it did so.
I was away at the time and not monitoring the market and had forgotten about this. The next day, ANZ came out with some terrible news and the share price dropped about .

Now, if I had only entered the ‘buy’ side of the contract, this would’ve been very terrible news. But, with a “spread” you can do fascinating things…. I thought to myself, “if the share price has dropped, that means my ‘way-out-of-the-money’ “sold” call option is now going to be very cheap” – cheaper in fact, than my bought position. (the share price was now about ).
Remember, this was a SOLD position, so why not buy it back when it’s practically worthless.
Well, I had to wait a few weeks for it to get to the price I was prepared to pay, but last week the US stock market took a huge dive and so the Aussie market followed the next day, particularly the banks.

The whole position (spread) had originally cost me 24.5 cents.
This comprised the BOUGHT option at a cost of .48 less the SOLD option for .235 = 24.5 cents.
Anyway, when the ‘huge dive’ took place last week, I was able to “buy-to-close” the original SOLD position for only 12cents.

I thought to myself … “my total cost is now 24.5 + 12 cents = 36.5 cents. All I need now, is for the share price to rise a small, so that the original BOUGHT option comes up to about 38cents and I can get out and break even.

I was prepared to wait a few weeks for this to happen, because I had noticed that ANZ was in a sideways channel (see chart below). Well, to cut a long tale small, the ‘huge dive’ on the US markets was followed by a huge rally the next day, so the Aussie market followed (wagging its tail). The ANZ shares took off, so that my original ‘bought’ .50 call option was now worth 65c. I sold for an overall profit of 78%!!

We all like to share our successes. This impressed me with the flexibility of ‘debit spreads’ – how you can turn a setback to your advantage.

Topics: Uncategorized | 1 Comment »

One Response to “Pls explain in laymans terms the following online example of Option debit spread strategy,What's the downside?”

  1. mrzwink Says:
    November 20th, 2010 at 5:31 pm

    to be honest you did horribly there.

    september 2008 i entered a call spread on Randstad for 2009 i made a total of 800% profit there.
    that same month i also entered into a call spread on ING for dec 2010 that made me a total of 667%

    i have many more spreads running til 2013 most of them are already halfway into the money. The ranges of maximum return on investment on a call spread range from 200% with lower risk to 1000% with very high risk.

    - Firstly: the downside of debit spreads is that the maximum loss is 100% (your entire investment.)
    - Secondly: a downside is that failure to perform by the underlying value will erode your investment making it worth less over time.
    - Thirdly: when your spread goes fully in to the money prematurely (way before expiration) your money is stuck til expiration unless you close the position (which is always vs a loss because the time-expectance value is still included)
    - Lastly: you need performance in a very small range on the underlying value. which makes your position rather volatile for change. in the money one day could quickly go to out of hte money next month.

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