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Learning options – debit spreads with AAPL

As I continue learning options as a tool to make more money than just with dividend investing I moved into reviewing debit spreads.

If you follow my blog, you know that I do not prefer debit trades much. With debit trades, you pay up front for the trade and then you have to hope for the stock to move your direction and enough magnitude to overcome time decay in order to make money.

If that doesn’t happen, you lose.

For example, if you buy calls, the stock must move up in your direction. It also must move fast and strong enough. If it doesn’t move up and it goes sideways, you lose money. If it moves up, but slowly, you lose money. Why? The time decay will destroy the option.

The same goes with put options.

With credit trades, time is on your side. Unlike debit trades, your profit is limited, but your loss is unlimited. The debit trade limits your loss and makes your profit unlimited, but the probability of profit is very low.

Credit spreads can help you with limiting your loss. But when I heard about debit spreads I originally rejected them, because I wasn’t in favor of paying up front for a trade. Unlike debit spreads, with credit spread you receive premium right away, but then the stock must stay below (for calls) or above (for puts) your strike in order to keep that premium. But the trade is not directional. As long as the price stays below or above your strikes, it doesn’t matter, what the stock does. It can go sideways, up, or down. As long as it stays below or above your strike, you will make money at expiration.

So what is the difference between a credit spread and debit spread?

Besides I didn’t like paying the premium I realized an interesting and huge difference between the trades.

Here is an example.

I will use AAPL to demonstrate the difference.

A debit spread against AAPL which at this writing is trading at $111.25 a share

Debit Spread

If I decide to buy a debit spread, it would look like this:

BTO 1 AAPL Dec 2014 120 Call
STO 1 AAPL Dec 2014 125 Call

@ 0.24 LIMIT GTC (debit)

Max loss: $24
Max. Gain: $476
Margin requirements: $33.50

This will be a bullish trade and I will start making money anytime the stock moves above the current price. Whenever the stock moves above $111.39 a share I will make 0.05 a contract. Of course, in order to make some real money, the stock would have to move up more than that, but theoretically the trade will become positive even if the stock goes slowly up. If you buy calls out right, you will be losing money.

With this trade, you make a full profit of $476 (1983.33%) per contract when the stock goes above $140 a share. If the stock goes above 125 strike, you will make $256 profit (1066.67%).

Looks cool so far, right?

Credit spread

In order to create a same bullish credit spread (a synthetic trade), you would have to sell put spread (bull put spread). But for the sake of this example, we will use a call credit spread which will be bearish:

STO 1 AAPL Dec 2014 120 Call
BTO 1 AAPL Dec 2014 125 Call

@ 0.24 LIMIT GTC (credit)

Max loss: $476
Max. Gain: $24 (5.04%)
Margin requirements: $486.50

Can you see the difference? If not, let me put both trades next to each other. See the table below:

  Debit Spread Credit Spread
Max. Loss $24.00 $476.00
Max. Gain $476.00 (1983.33%) $24.00 (5.05%)
Margin $33.50 $486.50

I hope now the difference is visible very well, isn’t it?

For this reason I decided to give it a try and open a debit spread against AAPL. I will risk $24 to make $256 if the stock gets above 125 strike. Literally my risk to reward ratio is 1:10 (I risk 1 to make 10) while with credit spread I would risk 10 to make 1.

As I am not sure yet how this trade would proceed in different situations, the best way to learn for me is on a live trade. And since I will only risk $24 I think I can afford this learning on the go trade.

I placed the order right now and I will watch this trade carefully and report how that trade goes.

Happy trading!

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