Track That Trade 111212 Debit, ITM call spread

In response to a request at one of our live meetings and the (edited) accompanying e-mail below, let’s look at initiating a debit spread. I’ll use the requested GDX as the underlying (even though I know nothing about this ETF). Remember this is a trade for discussion, never a real-world trade.

Late note: As I’m writing and communicating further with our questioner, I’m getting the bigger picture, and now the response could easily be turned into a full length book. This post contains some important lessons for rookies, so don’t be surprised to see some of it repeated in future posts.

Hi Mark,
Yesterday I attended an Option Express presentation and I want to ask you about one of the examples that was used, namely buying debit spreads.

Here are details: Let say that a trader wants to buy an equity, but understands that it is prudent to hedge the trade. Instead of buying the equity, he buys ITM calls, limiting downside losses. To lower the cost, he sells OTM calls. The idea is that this trade is similar to a covered call, with less risk.

When finding the options to trade, the presenter was picking specific probabilities for not having any loss and maximum profit – when choosing strike prices and expiration dates. He did not elaborate on the exact criteria.

Could you please initiate this type of trade with some comments about this strategy. We may pick an ETF like GDX or anything else. The result of gain or loss is irrelevant I just want to see how to make these trades.

The reason I am asking for this trade is to learn something about analysis how to prepare a trade, how to access a risk, how to make this process objective similar to what you did for iron condor.

The message offers many points for discussion. Some I can handle, others, I cannot. But let’s take this discussion one step at a time and get started with the trade.

Assumptions

Trader is mildly bullish
Trader wants to own an ITM option; it behaves more like stock than OTM or ATM options
Trader wants to reduce cost, and limit profits by selling an OTM call option

The Underlying

The Market Vectors® Gold Miners ETF (GDX) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of NYSE Arca Gold Miners Index (GDM). GDM is a modified market capitalization-weighted index, and provides exposure to publicly traded companies worldwide involved primarily in gold mining, representing a diversified blend of small-, mid- and large- capitalization stocks. As such, the Fund is subject to the risks of investing in this sector.

Current price: $55.79

GDX Call Options


Let’s next look at this statement: “the presenter was picking specific probabilities for not having any loss and maximum profit.” I must confess that I have no idea how to do that.

First, when we consider ‘maximum profit’ then the obvious solution is not to sell any OTM call option. When we own the call outright, that’s the only way to attain a maximum profit. Any time we sell a call, profits become limited.

Next figuring out: “probabilities for not having any loss” – Ive decided that something has been lost in the conversation. The best guarantee for having no loss is to sell a spread with the greatest chance of being ITM when expiration arrives. That means selling a call option with a high delta, and that in turn tells me to sell the 56 call (the call must be OTM). The next best way to insure a profit is to spend the least cash on our ITM option [The thought process is different if we are not using ITM options]. That translates into buying the 55 call.

Thus, buying the GDX Jan 55/56 call spread gives us the best chance to not have any loss – when the requirement is to buy an ITM call and sell and OTM call.

Trade phiosophy

There is no BEST spread to trade.

Which call to buy depends on how much downside risk the trader intends to take. We have to choose between a high-delta call option which comes with little time premium and thus, small negative theta – and a less expensive option, with a smaller maximum loss potential, but which comes with much greater time decay.

Which call to sell depends on whether the trader seeks safety or potential profit as the trade objective. It depends on how bullish the trader is, and just where he/she is willing to cap profits.

I have to assume that this trade is being made to earn a trading profit, and is not intended to be part of a longer-term investment program.

Trade selection

We are limited to buying an ITM and selling an OTM option
I’ll assume a bullish bias, but the idea is to earn a profit, not necessarily a huge profit.

In this example, it’s not easy to make a final choice. I’ll choose the 54/57 call spread, paying a debit of approximately $1.62, assuming I can make the trade at one penny better on each side of the bid ask spread ($1.55 to $1.64). I’m buying the 60 delta call and selling the 43 delta call.

This is a 3-point spread, and the maximum profit is $1.38 ($3.00 minus $1.62), less commissions.

Important note: This trade is equivalent to selling the GDX Jan 54/57 put spread and collecting $1.38.

Trade rationale

Why would a trader make a trade of this type?
There is a multitude of scenarios that a trader encounters. One great aspect about options is that they are very versatile and can be chosen to meet a variety of needs. Because of that, this discussion can easily be turned into a complete book on how to use debit/credit spreads.

When bullish we can by a call spread. We can sell a put spread. It is mandatory to understand that there is no difference The trades lead to the same results – when the strike prices are identical and the options expire at the same time.

Why anyone chooses to buy a call debit spread instead of selling a credit spread is personal. There can be psychological reasons for feeling better about owning option spreads rather than selling them. The only logical reason that occurs to me is that the spread owner is in control, if and when there is a decision about exercising one of the options. Many traders fear being assigned an exercise notice, and prefer not to sell spreads.

Why buy ITM calls?

The trader who thinks about covered call writing would want to own ITM calls. We’ve already talked about the idea that owning ITM calls is a far less risky (compared with stock ownership) when taking a bullish stance.

Then, selling an OTM calls feels right to most covered call writers [I admit a bias when I used to write ITM calls to reduce potential profits and the chances of losing money.]

Thus, the trader who thinks like a covered call writer would prefer a trade of this type: Buy ITM call, sell OTM call. It’s likely that the equivalent put spread sale never occurs to this trader. There is another consideration.

The equivalent trade requires buying an OTM put and selling an ITM put. This idea is foreign to most put spread sellers. Why? Because of the way we think about trades. Put spread sellers are psychologically wired to think about making money by seeing the options expire worthless. They sell OTM options and expect them to remain OTM. That is a clean and simple thought process. Selling options that are already ITM just doesn’t feel right. There’s no good reason for this, but it is nevertheless true.

Choose strikes

Choosing the option to buy is a simple process and involves compromises. Do you want a higher delta option with much less time decay? That option is most similar to stock, but it does come with downside risk. Or, you may choose an option (as I did in this trade) with a lower (60) delta and which comes with more time decay and less risk. It’s always a difficult compromise.

Selecting which option to sell depends to a large degree on the trader’s goal. Covered call writers tend to think in terms of selling OTM options, allowing them to earn a big profit when the stock rises. There is often that optimism that places potential gains ahead of taking less risk. [Selling options with more premium reduces downside risk, at the expense of a more limited upside.]

Summary

I see trade selection as a fulfillment of the needs of the trader. I don’t see it as picking the ‘best’ trade, or finding one that will ‘not have any loss’ or which will produce the ‘maximum’ profit.

There are aggressive, wildly bullish traders. They would choose far different options than the conservative covered call writer.

In my Introduction to Option Series, Parts 3 and 4, there is a lengthy discussion of covered call writing and how to go about deciding which call is appropriate to sell. That thought process is exactly the same when choose which option to sell in this type of spread. To me, the lesson here is that when you learn something it transfers. We don’t think about selling calls when writing covered calls any differently than we think of them when writing calls in a bull spread that begins with owning an ITM call. Lessons transfer.

My thoughts on this trade

I don’t like it.
But that is my personal bias.

When I want to take a bullish position on a stock, I want to earn a ‘decent’ profit from the trade. My conservative philosophy is that I prefer to earn less and have a higher probability of winning.

GDX OTM puts

Thus, if I were trading this index (not in a million years!), I’d choose something very different. I’d probably sell the Jan 47/49 put spread, collecting ~ $0.29.

It’s obvious that the trade being tracked offers a much higher profit opportunity: $1.32 for a 3-point spread, vs. $0.29 for a 2-point spread. But I have different goals than the trader who makes the featured trade. I also like the fact that my short option carries an 18 delta, meaning that I have a very good chance to see these options expire worthless (not that I would wait that long to exit).

Update Dec 20

GDX is currently $53.00 and our spread is $0.95 bid; $0.99 ask.
Thus, the trade is underwater.

As always, when making a directional play, we cannot anticipate any profits unless the stock moves our way. This is one of the top reasons why I don’t like this type of play. The stock must rally for the trader to earn a profit. When you have a strong bullish bias, buying the ITM call spread can result in a profitable trade. However, I am more of a skeptic when it comes to people having the ability to directly predict market direction. Thus, I tend to play higher probability, but less rewarding, trades.

I’d prefer to sell a put spread.

Dec 20. GDX Jan puts

There are several viable choices, but today, I would try for the Dec 47/48 put spread. The premium would probably be $0.14. I know that’s a tiny premium, but this is a one-point spread. For traders who prefer more premium, I’d choose a 2-point spread. Perhaps the Jan 47/49. I don’t have an opinion on this underlying, so that makes it difficult to choose. However, my point is that I’d prefer to take the higher probability trade, even when the profit potential is less.

higher probability trade

Why is this a ‘higher probability’ trade? For that, we look at the delta of the option sold. In this example it is 17. Although we are not planning to hold through expiration, we know that the probability that the Jan 48 put will be in the money when expiration arrives is roughly 17%. Thus, there is a good chance that the puts will expire worthless, or that we can buy back the spread at a low price before expiration. When we buy a spread with one of the options being ITM – in this example, the 54 call carried a 60 delta – then there is a 40% chance that the underlying asset will decline and our long call option will finish OTM. That would make the spread worthless and the trader would lose the cash paid to open the position.

I prefer to have a 17% chance for the position to be in trouble than a 40% chance. That’s why the trade has a higher probability y of being profitable. However, potential profits must be considered. We don’t want to sell OTM spreads with a tiny premium – just to have a 98% chance of success.

Each trader must choose a spread that is appropriate for him/herself. I’ll have more to say about credit/debit spreads, but for the moment, there is no longer any reason to follow this trade.

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