Vertical Debit Spread – Directional Options Strategy

January 7, 2010

Vertical Debit Spread

The Vertical Debit Spread is a directional strategy and consists of purchasing an in the money option and selling an out of the money option of the same expiration month. A variation of this is to purchase an out of the money option and selling a further out of the money option.  If an investor is bullish, call options are used.  If an investor is bearish, then put options are used.

We are buying a more expensive option than the option we are selling.  Therefore, our cost to enter the trade is the difference in the price of the option we purchase minus the price of the option we sell (this results in a debit).  Our reward is the difference in the strike prices, which would more than offset the cost or debit incurred by entering the trade.

The maximum reward is a settlement in the underlying market that is higher than the higher strike for Call options, or lower than the lower strike for Put options.

This is a limited-risk strategy that gives the trader an extremely powerful psychological edge over the futures speculator.  Although futures traders use “stops” to protect against losses, often times, a futures position is “stopped out” and then the market reverses in their favor.  This experience (in particular if it becomes a pattern) can cause extreme frustration, apprehension and severely impede a futures trader’s ability to make intelligent decisions.

An options trader using a Vertical Debit Spread knows that risk is limited.  Also, with this strategy, if the market moves in the wrong direction, some of the losses are hedged with gains on the option that was sold. This strategy is especially good for traders that are good at picking market direction, but tend to trade on emotion and have trouble handling normal market “noise” or corrections (even if their trade is on the correct side of a longer term trend).  Essentially, the trader has a psychological edge, which can make the difference between a winning trade and a losing trade.

Note that in order to eliminate slippage, it is best to use limit orders when entering a Vertical Debit Spread.

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