
Benefits of Creating Wider Debit Spreads
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You will ideally want to set up a debit spread so that the break even price is just around the stock price. The break even price is determined by the spread width and the debit premium.
If the break even is just around the stock price, then it is possible that you break even or profit even if the stock price does not move.
If you have a 10 strike wide 95-105 call debit spread and the stock price is 100 ( in the middle ) the profit on the option is potentially 5 dollars ( 100 minus 95 ). You will want to collect a premium of about 5 dollars.
If the stock price does not move at all, the short strike will expire worthless.
The long call, however, will be worth about 5 dollars ( 100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.
Building Blocks are combinations of buying and selling of calls and puts
If the stock moves in your favor and moves above the short strike, you will achieve maximum profit. The maximum profit is calculated by the width of the strikes minus the debit you paid.
In this example, the width is 10 and the debit it 5. So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.
If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade. Maximum loss is simply the price of your debit premium. In this case it is 5 dollars.
You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.
Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread.
If the original debit was 5 dollars and you were able to get another 30 cents. Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.
If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed. Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide. Your profit is based now on a strike width of 5 minus the debit which is now 4.7.
If the stock price does not move at all, the short strike will expire worthless.
The long call, however, will be worth about 5 dollars ( 100 minus 95 ) which, if you bought the spread for a 5 dollar debit, you would break even on the trade.
You might not want to manage this trade if you are at least breaking even, It might be hard to move the short strike down for a credit and it might be harder to move it down and still pay for the expense of commissions. This scenario will depend on whether or not you can move it down for a reasonable credit.
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Checklist considerations
- this management strategy at least will decrease the cost basis and maximum loss
- If we roll the option for a debit, we will take on extra risk and possibly lock ourselves into a bigger loss
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FYI- Would rather use strategies that sell premium rather than using debit spreads
Set up in low volatility environments
Straddle the stock price
Buy an ITM option and Sell an equidistant or slightly closer OTM option
Set up so that the break even is just around the stock price or ideally even just a little bit better
Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success
