Let’s talk about option debit spreads.
One of the things that I like about option debit spreads is, they reduce cost and they also reduce the break-even. So we want to trade call debit spreads when we expect the market to go UP, and we want to trade put debit spreads if we expect the market to go DOWN.
Debit Spread Example: TGTX
I want to show you a very specific example of a trade that I had in my account a while back. To do this, I want to go to the PowerX Optimizer. This is the software that I personally use to find the best stocks to trade.
According to the PowerX Optimizer I had seven positions in my account. One of the trades that I took was TGTX. So TGTX came up as a signal, and as you can see, PowerX Optimizer tells me exactly when to enter.
According to The PowerX Optimizer, we should enter as soon as TGTX goes above $20.43, and we are expecting the stock to go as high as $25.37. That’s when we want to take profits and place our stop loss rather quickly at $18.61.
Looking at the chart above, you can see my stop loss and my profit target.
The PowerX Optimizer makes it easy for me to find the best stocks.
3 Things You Need To Know When Trading
When it comes to trading, there are three things that you need to know:
Number one – What to trade? Are you trading stocks or options?
Number two – When to enter.
Number three – When to exit. When to exit with a profit, and when to exit with a loss.
Going back to TGTX, looking at the options tab PowerX Optimizer told me that I should trade the 20 call with an expiration at 8/21.
So here for the example, we would have bought a 20 call. PowerX Optimizer told me that I should spend no more than $2.15 when buying this option, so I bought it for $2.10 and I traded two options.
Placing An Option Debit Spread
Let’s go with one option as an example for now.
The max risk is exactly the amount that you’re paying for this call. You cannot lose more than the money that you pay for the call. The maximum reward is unlimited. Our break-even, this is where we are taking the strike price of the call which is $20 plus $2.10, is at $22.41.
As soon as the stock moves above $22.41 we will start making money. At the time of writing this article, TGTX was trading at $20.40. So it takes a little bit until we make money.
We don’t expect this stock to move much higher than $25.35 according to what the PowerX Optimizer tells us, so based on the past performance of this stock, we can calculate how likely it is for the stock to move how far.
We don’t only know based on the indicators that TGTX is more likely to go up, but by measuring the moves that happened over the past year, we can also sort of predict, and I say “sort of predict” because we never know, but, $25.35 is a realistic goal for this stock.
I mean, this stock could easily move $5 here, right? Since we do know that it won’t go much higher than $25 here is what we can do.
We’re still buying the 20 call, but at the same time, we are selling the 25 call. This would be a debit spread.
If you’re unfamiliar with debit spreads and you’re not quite sure what this is all about, I did a video explaining it in detail. You can check it out HERE.
What is the cost of this spread? Let me explain it by showing you exactly I did.
I sold the 25 call for $0.50 as shown above.
I sold it for $0.50, therefore the spread no longer costs me $2.10 as when buying this option. It’s actually the $2.10 that I bought the 20 call for, minus the $0.50 that I received by selling the call. Instead of $2.10, it’s $160.
It turns to $160 because options trade in 100 packs, you cannot only buy one option. One option gives you the right to buy or sell 100 shares.
If you need some more explanation I have a free course called Options 101 that you can check out HERE.
As you can see, we are reducing our buying power from $210 to $160. This now becomes our maximum risk because it’s what we paid for this spread.
Now, the max reward is no longer unlimited because now it is limited to $25. If the stock moves above $25 we are capped.
But you see, we only expect the stock to move to $25.35 anyhow. I’m good missing out of the last $0.35 here. The total we can earn if the stock reaches $25 is $680.
A cool thing here is that our breakeven is now reduced because our costs are reduced. Our breakeven is now at $21.60. Again, it’s the 20 plus the $1.60 that we paid for it.
The reward cap, if it moves above $25 we are caped. Let me show you exactly what this looks like.
The risk graph above is once the stock moves above the 25 strike that we sold. So first of all, the line that you see here is what happens at expiration on August 21st. The orange line is the theoretical price of the spread as we are trading it.
And you see, yeah, it takes a little bit here until we start making money. Right now, this position is actually slightly down $30. Not a big deal, right? And we know that our max risk per one option is capped at $160. Here I’m trading 2. So basically, the $30 means only $15 for one option. I just decided to trade 2.
Anyhow, we can take a look at this and we know that as this stock moves higher, we will start making money. But you also see as the stock moves lower we lose a little bit of money, but not as much as if we had only traded a call.
By trading a spread here we’re doing exactly what our goal is. When I compared the different spread options strategies, I said we want to trade debit spreads so that we can reduce costs, which we did from $210 to $160, and we are reducing our breakeven, which we also did from $210 to $160.
I hope that showing you a very specific example of a spread in my own account has been helpful.
The account that I’m sharing is a rather small account, around $20,000, where I’m following a very specific trading plan. If you would like to have the plan I’ll be happy to send it to you, just CLICK HERE.