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In the past 10 years, I've taught well over 300,000 traders about many different moneymaking strategies.
Whenever we talk about a new options trading strategy, the first thing I always say is, "practice before you spend any real cash on a live trade."
And the second thing I always say is, "you should never risk more than 2% of your account on any one trade."
That means that for an account with, say, $25,000, you should never risk more than $500 on any one trade.
On occasion, though, you may spot a trade that you believe in your heart can make you big money.
The only problem is… it costs more than $500.
So can you still make a profit without completely ignoring your risk management?
The answer is yes!
Create a Call or Put Debit Spread to Hedge Your Risk on a Higher-Priced Option
We recently talked about risk graphs and how you can use them to "see the future" of two straight directional options trading strategies, long calls and long puts.
Today, I want to use a risk graph to show you the risk and profit potential on two of the debit spreads I often like to use during volatile times – the debit call spread (or bull call spread) and the debit put spread (or bear put spread).
Remember, a risk graph will show you the theoretical profit potential you have when trading long calls and long puts. Keep in mind that your profit potential is unlimited when buying calls, but your maximum profit potential when buying puts is limited since the stock can only drop as low as zero. The most you can risk (or lose) on a long call is the amount of money you spent getting into the trade. The most you can risk on a long put is the same – the amount of money you spent on the trade.
With a debit call or debit put spread, what you're really doing is "selling-to-open" an option against the one you "bought-to-open" to hedge the risk of your trade. This means that you're simultaneously buying and selling either calls or puts (on the same order ticket) to offset the cost of the calls or puts you bought.
Now as I mentioned above, the best way to manage your risk is by making sure that you never risk any more than 2% of your account on any one trade. That's a maximum risk of $500 per a $25,000 account.
But if you want to make money off an option that costs more than $500, the best way to do it is by creating a debit call spread or debit put spread.
Well, you can buy-to-open that option priced higher than $500 ($5.00) and sell-to-open the same number of contracts for another option that has a different strike price but the same expiration month as the option you bought-to-open.
By selling-to-open this other option, you bring some money back to your account. Now this is all part of the same trade… these two options are to be opened at the same time on the same order ticket. I recommend consulting your broker to find out the commissions for this type of trade.
You generally want to close these two options at the same time. To do this, you simply reverse your orders: sell-to-close the option you bought-to-open and buy-to-close the option you sold-to-open. Again, you'll want to enter these orders simultaneously on the same ticket.
I've nicknamed these two trading strategies – debit call spread and debit put spread – the "loophole" and "reverse loophole" trade. Loophole in this context means you offset your cost by looping some money back to your account through selling-to-open an option against the one you bought-to-open.
Now let's take a look at these two strategies on the good ol' risk graph…
The Debit Call (or Bull Call) Spread… AKA the Loophole Trade
Here's an example of a debit call spread – or loophole trade – on LinkedIn Corp. (NYSE: LNKD). We're going to use the LNKD June 17, 2016, $125/130 calls. This $500-wide spread ($5-wide spread) trade example is below…
On this order, you buy-to-open the $125 calls while simultaneously selling-to-open the $130 calls. This creates a vertical spread with a limit price of $2.75 (or $275), which results in a debit to your account of $275.
Here's a look at the risk graph for this trade:
Remember, you can look at any time interval (represented by the four colored lines) on the risk graph. With these debit spreads, I like to focus on the maximum loss and maximum profit price points on the graph.
Now the stock has to be at least $0.01 above the strike price for the option you sold debit call spread in order for you to realize your maximum profit. Keep in mind that the market has the right to call away (or buy) the stock from you at $130, whereas you have the right to buy the stock for $125. Your broker should know this to make sure that actually happens). That $500 ($5.00) is offset by the $275 ($2.75) cost, leaving you with a profit of $225 ($2.25).
Your maximum reward is represented at expiration by the black line on the risk graph. You can tell where that price is when the black line goes up vertically. This shows that no matter how much higher in price LNKD goes, your maximum profit can't get any higher than that $225 profit.
Your maximum risk is the total cost of the trade, which is $275. This is represented on the risk graph by the black line. You can tell where that price is when the black line goes down vertically.
And no matter how much lower LNKD goes beyond $125, your risk is capped at $275.
The Debit Put (or Bear Put) Spread… AKA the Reverse Loophole Trade
Now let's look at an example of put debit spread – or reverse loophole trade – on Tesla Motors Inc. (Nasdaq: TSLA). We're going to use the June 17, 2016, $205/215 puts. This $100-wide spread ($10-wide spread) trade example is below:
On this order, you buy-to-open the $215 puts while simultaneously selling-to-open the $205 puts. This creates a vertical put spread with a limit price of $5.17 (or $517), which results in a debit to your account of $517.
Now you can ask for a debit of whatever you like, within reason. So if you want a debit of $5.20 or $5.15, you can certainly ask your broker for it.
As I mentioned, this is a $10-wide spread, and I tend to look for a wider spread of 10 points on stocks that are in the upper $100-$200 price range – usually closer to $200 is more likely.
The reason I recommend looking for this type of spread is that stocks in the $200 price range easily move five points or more – so you're able to find trades with an increased probability of making you money.
This is how the risk graph looks for this trade:
The stock has to be at least $0.01 below the strike price of the option you sold for a debit put spread in order for you to realize your maximum profit. The market has the right to put the stock to you (or sell you the stock) at $205, whereas you have the right to sell the stock for $215 (and your broker should know this and make sure it actually happens). This $1,000 (or $10.00) is offset by the $517 ($5.17) cost, leaving you with a profit of $483.
Your maximum reward is represented at expiration by the black line on the risk graph. You can tell where that price is when the black line goes down vertically. And no matter how much lower TSLA goes, your maximum profit is capped at $483.
Your maximum risk is the total cost of the trade, which is $517. This is represented on the risk graph by the black line. You can tell where that price is when the black line goes up vertically.
And no matter how much higher TSLA goes in price above $215, you can't lose more than the original $517 you spent to get in the trade – even though this amount exceeds your maximum risk of 2%.
One Final Note on the Probability of Debit Spread Trades
As you know, stocks can move in three directions only: up, down, or sideways. With a long call or long put, the stock HAS move in the anticipated direction (up for calls and down for puts) for you to make money. This gives you basically a 1-in-3 chance for profitability.
But when it comes to a call or put spread, the stock can move in the direction you need it to or stay right where it is… and profitability can be achieved.
Now remember, the more risk, the more reward… just as the less risk, the less reward. A call or put spread is a way to minimize your risk, which decreases your profit potential.
However… a higher probability might be worth this trade-off to you to – especially on an expensive option.
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About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.