Hey everyone.
This is Kirk, here again at optionalpha.com where we show you how to make smarter trades.
In today's video, we want to talk about debit spread adjustments that you might possibly
make.
Because debit spreads are low probability strategies that we should use sparingly in
our portfolio to begin with, there are a very few reasons to adjust these 50/50 bets as
you go throughout the year.
On the left side of the screen, this is a very typical debit call spread that we might
make where we’re getting a little bit directional on the market and we’re buying an option
that’s in the money, selling an option that’s right out of the money, trying to take advantage
just of the market movement with a breakeven price very close to where the stock is currently
trading and that’s why these end up being 50/50 bets.
In fact, we might adjust one or two all year out of 50 plus or 100 plus trades that we
make in this type of strategy just to give you an idea of how little we tweak them.
We mainly use these in our portfolio as a means to rebalance other positions.
If we’re getting a little bit directionally long or a little bit directionally short in
the market, we’ll use debit spreads to get a little bit more of rebalance in our portfolio
because they have such a great Delta for a spread compared to using just long options
or long stock.
That said, there is one particular market setup that we’ll cover today in the video
in which we will hedge this position and which it actually makes sense to hedge this type
of position.
Remember that when we enter these trades, we do so during low implied volatility markets
and are directionally bullish.
That's the setup of when we enter the trade.
There’s a different setup as to when we actually make that adjustment.
Here's the setup that we need to make this special adjustment to a debit spread.
First, we want to make sure that the stock is moving far out of the money and away from
our breakeven points.
Basically, we want to make sure that the stock is far enough out of the money and basically,
the trade is losing money to the point at which an adjustment is worthy.
These are low probability trades, we’re going to do them in a low position size, so
we’re not risking a lot of money to begin with, so it’s really got to be a trade that’s
gone completely against us or very far against us.
Number two is that implied volatility has got to increase as a result of this.
If you’re trading directional call debit spreads and the market starts to go down,
we’ll typically see a rise in implied volatility anyway as a result, but this is also a requirement
of this trade.
If this happens, number three, what we’ll do is we’ll sell a naked option against
this position and try to take in a credit that is worth somewhere around the debit that
we paid to neutralize the position while still leaving an opportunity to make some money
if the market does rally back higher.
This is what that new payoff diagram would look like.
It has a combination of a debit spread on the left side of the payoff diagram and then
you can see that naked call and that undefined risk feature as it heads lower.
Let’s actually go to Thinkorswim here and we’ll take a look on the broker platform
at an example.
Let's say for example that you were trading USO recently.
USO closed today at about $17, but let's say that you had traded the 18/19 debit spread
originally.
What I’ve done is I’ve created basically a simulated trade here to say – If you had
traded an 18/19 debit spread maybe a couple of days ago, maybe a week ago, you probably
paid around $.50 or about half the width of the strikes which is what we usually end up
paying for some of these debit spreads.
If you paid about $.50 for this debit spread, it means your breakeven is about 18.50 or
so.
You can see on the profit loss diagram here that the stock is currently trading deep out
of the money because we want our stock to trade in the money or we want it to go higher
and you can see our breakeven point is right about here.
The stock has definitely made a huge move against our position.
We start to look at the chart here of USO and you can see that the stock has definitely
had a long continued move lower.
But as it's done that, implied volatility has gotten really, really high, up in the
99th percentile.
That leaves us an opportunity to sell options that are very, very expensive.
What we’re going to try do is we're going to try to go out of the money and sell an
option that’s worth somewhere around the debit that we paid because we basically want
to get most of our money back.
In our case, we’re going to go one strike out of the money here from the original spread,
the 18/19.
We’re going to go to the 20 calls which are currently trading for about $44.
We don't get all of our money back in this case, but we’re going to go ahead and sell
this call for $44 and you can see this new risk profile looks like this.
It does have undefined risk past about 21.
You can see the breakeven point now on this trade is about 21, but with the stock currently
trading right where it is, we actually only lose about $6 on the trade versus losing about
$50.
What I do like about this position is that if the stock does end up starting to rally
back which really would be bad if it had a huge rally back higher is that when stocks
tend to rally higher, we typically see a drop in implied volatility.
Basically, what’s going to happen is that the stock will have to go through this big
window of profit that we have and it’ll be on us basically to close out the trade
at a profit before the trade gets up to our breakeven point.
In most cases, when we actually do make this trade and this setup happens, we’re able
to close out the trade at a profit if the stock rallies because implied volatility drops
and the value of this option that we’ve sold for $44 drops as well, so that helps,
plus the stock is moving higher which helps our original call spread position.
You can see why this is a really good adjustment, but it's very particular for the type of market
situation.
With these debit spread adjustments, it does create an unlimited risk position, so you
just have to be aware of that which is why it’s important that you sell this option
at a very high probability of success level.
We may only do this one or two times all year, but we don’t suggest this adjustment for
beginners.
This is definitely more of an advanced adjustment.
You want to make sure that you’re doing these only if you completely understand the
risk that’s involved.
As always, I hope you guys enjoy these videos.
If you have any comments or questions, please add them right below in the lesson page.
Until next time, happy trading!