Q&A
Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. | 
Tom Gentile of Optionetics |
CREDIT AND DEBIT SPREADS
What are some money management tips for credit and debit spreads? Specifically, when should I get out if a spread goes against me? -Bob
Great question. By purchasing or selling spreads, you've minimized the risks of stock ownership while maintaining a greater potential return on investment. However, just because you have taken the measure to place a spread trade doesn't mean you should just "set it and forget it." So when exactly is the best time to get out of a spread? Since you asked for both a debit and credit spread, it requires two different answers:
First, the debit spreads. Since your maximum risk is limited to the debit of the trade, you can approach your exit strategies from a couple of angles. You should avoid putting on debit spreads in which you're not willing to lose the entire amount in the event of a gap opening that moves against you. That's not a likely situation on every trade, but you should always consider the worst possible scenario before entering. The trick is to keep the debit as small as possible while maintaining a high reward-to-risk ratio. Generally, it's a good idea to set up these trades with the ability to make at least $2 for every dollar risked, but never less than $1 for $1. On a spread in which there are $5 between the strikes, that would equate to a risk of $1.65-2.50. Be careful of risking any more than half the spread. If you're only trading a couple of spreads at a time, then commissions are a consideration as well, and can add to the expense of the trade by as much as $1 in some cases; this makes any kind of profit extremely difficult.
In lieu of a price stop, you should consider using time stops - always getting out of the trade with at least 30 days to expiration. That way, should the underlying move against you or not at all, you're out of the trade with at least some of the time premium saved. The greatest amount of time decay in an option life is in the last 30 days before expiration, so it's a good idea to get out before then.
Many traders will use a mental stop-loss to get out of trades. The reason you can't use a real stop-loss is because most brokers will not accept stops on spreads. If you're going to use the mental stop, the problems are twofold: First, if you're only trading a couple of spreads at a time, then your commissions will represent a significant portion of the total premium paid for the trade. And second, with most brokers, you will not be able to enter stop-loss orders on spreads; it creates a cumbersome and impractical situation for many. You would have to watch the prices of your options constantly, and might be wiggled out of a trade prematurely. Logically speaking, you're better off looking for good spreads that cost $1.50 without the intent to stop out than to buy spreads for $3 with the intent to stop out at $1.50 (due to the additional cost in commissions).
As far as credit spreads go, should your analysis of the trade be incorrect and the trade move against you, there's not much you can do other than roll out of the trade by buying back the spread and selling another one immediately at the next distant expiration. You could use different strikes, of course, but essentially, the loss in the first trade is real and the risk in the second trade could be just as great, should you use different strikes. One strategy for exiting credit spreads is to buy back the spread when the cost equals twice the credit.
These days, some of the best credit spreads have been on stocks that have been beaten up and are trading under $25. There's still a lot of volatility in some of these issues, so they offer premiums to suck in as a credit. Optional stocks under $25 have strikes that are $2.50 apart. When trading credit spreads, you want to take in as much credit as possible while leaving your exposure to risk at a minimum. Often, you can look for credits as large as $0.75 to $1 at-the-money?. Since the risk in a credit spread is equal to the difference between the strikes minus the credit, it's a good idea to look for trades in which the distance is minimal, so you don't get caught up in a big reversal in the underlying. Taking in $1 on a 2.5-point spread is better risk management than the same credit on a five-point spread.
Since credit spreads can be capital-intensive when buying back due to the bid/ask spread between options coupled with commissions, something else to consider would be to purchase an additional long position with the same month and strike as what you have in the spread. Essentially, what this does is convert the trade into a ratio backspread. Be careful on something like this if there are fewer than 30 days left in the trade, however. Putting more capital into such a trade is taking on more risk than the original position dictated, but can offer nice rewards if the reversal in the underlying is explosive.
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Originally published in the June 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
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