Spreads are another favorite of mine. There are two types of spreads I trade using either Calls or Puts. They are Credit and Debit Spreads.
A credit spread means that you receive money when you place the trade and hope that the position expires worthless.
A debit spread means that you pay money when you place the trade and hope that the position will increase in value on or before expiration.
In each case they consist of a long and a short option position.
Example of a Credit Spread.
This is an example of a credit spread using Calls. Let’s assume that Facebook (FB) is trading at $152.00 and it is July 1st. You believe that FB will stay at this level or go down so you sell the AUG17 $155.00 Call for $1.25 and you buy the AUG17 $160.00 Call for $.50. You receive a net credit of $.75 or $75.00 per contract.
As long as FB closes below your short position of $155.00 on AUG17 you get to keep the entire $75.00. Your breakeven on this trade is the short position plus the credit you received or $155.75. The most you could lose if the difference between long and short minus your credit or $4.25 ($160 – $155 – $.75).
If you thought that FB was going up in value you could use puts the same way. If FB is at $152.00 you could sell the $150.00 put for $1.00 and purchase the $145.00 put for $.40. Your credit would be $.60 or $60.00 per contract.
As long as FB closes above $150.00 you get to keep the entire credit. Your break even on this trade is your short option price of $150.00 minus your credit of $.60 or $149.40.
Example of a Debit Spread.
We will use Citi Group (C) in this example. You check the chart and find that C is trading at $67.00 and you believe it will continue higher. You purchase a $67.50 call for $.75 and sell the higher $70.00 call for $.15. You purchase the spread for a net debit of $.60 or $60.00 per contract.
The most you can make on this trade if C goes up to $70.00 is the difference between your short and long minus the debit you paid or $70 – $67.50 – $.60 or $1.90 ($190.00) per contract. Your breakeven is your long call plus your debit or $68.10 ($67.50 + .60). The most you can lose is what you paid for the spread or $60.00 per contract.
If you believed that C is going lower while trading at $67.00 you could purchase the $65.00 put of $1.00 and sell the $60.00 put for $.25 or $.75 ($75.00) per contract.
If C goes down to $60.00 or below before or on expiration then you would make $4.25 ($65.00-$60.00-$.75). Your breakeven is the price of the $65.00 put your purchased minus the debit you paid of $.75 or $64.25. The most you can lose is what you paid for the spread or $.75 per contract.
This is a simple explanation of a spread starting with out of the money options. You could use in the money options that would bring in more of a credit to start the trade or cost you more up front in a debit spread. Sometimes, I use those but they change the makeup the trade some. Those types of trades will be discussed more at a later time.