Debit Spread Adjustments

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In today's video, we want to talk about debit spread adjustments that you might make. Because debit spreads are low probability strategies that we should use sparingly in our portfolio, to begin with, there are very few reasons to adjust these 50/50 bets as you go throughout the year.

On the left side of the screen, this is a very typical debit call spread that we might make where we’re getting a little bit directional on the market, and we’re buying an option that’s in the money.

Selling an option that’s right out of the money, trying to take advantage just of the market movement with a breakeven price very close to where the stock is currently trading, and that’s why these end up being 50/50 bets.

In fact, we might adjust one or two all year out of 50 plus or 100 plus trades that we make in this type of strategy just to give you an idea of how little we tweak them. We mainly use these in our portfolio as a means to rebalance other positions.

If we’re getting a little bit directionally long or a little bit directionally short in the market, we’ll use debit spreads to get a little bit more of rebalancing in our portfolio because they have such a great Delta for a spread compared to using just long options or long stock.

That said, there is one particular market setup that we’ll cover today in the video in which we will hedge this position and which it makes sense to hedge this type of position.

Remember that when we enter these trades, we do so during low implied volatility markets and are directionally bullish. That's the setup of when we enter the trade. There’s a different setup as to when we make that adjustment.

Here's the setup that we need to make this special adjustment to a debit spread. First, we want to make sure that the stock is moving far out of the money and away from our breakeven points.

Basically, we want to make sure that the stock is far enough out of the money and basically, the trade is losing money to the point at which an adjustment is worthy.

These are low probability trades, we’re going to do them in a low position size, so we’re not risking a lot of money, to begin with, so it’s got to be a trade that’s gone completely against us or very far against us.

Number two is that implied volatility has got to increase as a result of this. If you’re trading directional call debit spreads and the market starts to go down, we’ll typically see a rise in implied volatility anyway as a result, but this is also a requirement of this trade.

If this happens, number three, what we’ll do is we’ll sell a naked option against this position and try to take in credit that is worth somewhere around the debit that we paid to neutralize the position while still leaving an opportunity to make some money if the market does rally back higher.

This is what that new payoff diagram would look like. It has a combination of a debit spread on the left side of the payoff diagram and then you can see that naked call and that undefined risk feature as it heads lower.

Let’s go to Thinkorswim here, and we’ll take a look on the broker platform at an example. Let's say for example that you were trading USO recently. USO closed today at about $17, but let's say that you had traded the 18/19 debit spread originally.

What I’ve done is I’ve created basically a simulated trade here to say – If you had traded an 18/19 debit spread maybe a couple of days ago, maybe a week ago, you probably paid around $.50 or about half the width of the strikes which is what we usually end up paying for some of these debit spreads.

If you paid about $.50 for this debit spread, it means your breakeven is about 18.50 or so. You can see on the profit loss diagram here that the stock is currently trading deep out of the money because we want our stock to trade in the money or we want it to go higher, and you can see our breakeven point is right about here.

The stock has made a huge move against our position. We start to look at the chart here of USO, and you can see that the stock has had a long continued move lower.

But as it's done that, implied volatility has gotten high, up in the 99th percentile. That leaves us an opportunity to sell options that are very, very expensive.

What we’re going to try to do is we're going to try to go out of the money and sell an option that’s worth somewhere around the debit that we paid because we want to get most of our money back. In our case, we’re going to go one strike out of the money here from the original spread, the 18/19.

We’re going to go to the 20 calls which are currently trading for about $44. We don't get all of our money back in this case, but we’re going to go ahead and sell this call for $44, and you can see this new risk profile looks like this.

It does have undefined risk past about 21. You can see the breakeven point now on this trade is about 21, but with the stock currently trading right where it is, we only lose about $6 on the trade versus losing about $50.

What I do like about this position is that if the stock does end up starting to rally back which really would be bad if it had a huge rally back higher is that when stocks tend to rally higher, we typically see a drop in implied volatility.

Basically, what’s going to happen is that the stock will have to go through this big window of profit that we have and it’ll be on us basically to close out the trade at a profit before the trade gets up to our breakeven point.

In most cases, when we actually do make this trade and this setup happens, we’re able to close out the trade at a profit if the stock rallies because implied volatility drops and the value of this option that we’ve sold for $44 drops as well, so that helps, plus the stock is moving higher which helps our original call spread position.

You can see why this is a really good adjustment, but it's very particular with the type of market situation. With these debit spread adjustments, it does create an unlimited risk position.

So you just have to be aware of that which is why it’s important that you sell this option at a very high probability of success level. We may only do this one or two times all year, but we don’t suggest this adjustment for beginners.

This is more of an advanced adjustment. You want to make sure that you’re doing these only if you completely understand the risk that’s involved.

As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below on the lesson page. Until next time, happy trading!