Option debit spreads can be a very useful and in some cases, lifesaving tool when trading. The following debit spread example shows how that, even when the price of the underlying financial instrument goes against you, it is still possible to make a nice profit on your investment. It just takes a bit longer, but it illustrates the superiority of this strategy over merely 'going long' on call or put options.
The following debit spread example was traded on the Australian market, but the principles can apply to any market in the world.
I entered an option trade on ANZ bank. It was a debit spread, in this case, a 'bull call 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 $18.50 / $19.00 spread.
On reflection, it was a bad time to buy, but hey - we all make trading mistakes don't we. I was distracted by other interests at the time and not concentrating on the market enough. The next day, ANZ came out with some bad news and the share price dropped about $2 (see chart - the first blue square is where I entered the bull call spread).
Now, if I had only entered the 'buy' side of the contract, this would've been very bad news. However, with a debit spread example like this, you can do interesting things.... I thought to myself, "if the share price has dropped, that means my now 'way-out-of-the-money' $19 "sold" call option is now going to be very cheap" - cheaper in fact, than my 'closer to the money' bought position. (the share price was now about $16). 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 big dive and so the Aussie market followed the next day, particularly the banks.
For this debit spread example, the whole position (spread) had originally cost me 24.5 cents with a view to making a max 50 cents. This comprised the BOUGHT option at a cost of $1.48 less the SOLD option for $1.235 = 24.5 cents. Anyway, when the 'big dive' took place, I was able to "buy-to-close" the original SOLD position for only 12cents (see 2nd blue square on the chart above).
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 little, so that the original BOUGHT option comes up to about 38 cents and I can get out and break even. I would've been satisfied with that.
I was prepared to wait a few weeks for this to happen, because I had noticed that ANZ was in a sideways channel. Well, to cut a long story short, the 'big dive' on the US markets that caused ANZ to fall originally, was followed by a huge rally the next day, so the Aussie market followed. The ANZ shares rebounded up toward the top of the channel (see chart again), so that my original 'bought' $18.50 call option was now worth 65c. I sold for an overall profit of 78%!!
If I had not taken out this debit spread example and merely gone long on $18.50 call options, I might have made a loss instead of a profit due to time decay - or possibly broke even when the share price surged again the next day, to $20.
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. Options are so flexible! That is why I prefer them over other derivative instruments such as futures or CFDs.
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