One more thing about net debit spread: risk management.
music selection: “Heroes” — David Bowie
I have been buying three spreads per week, one bearish, one bullish, and one market neutral in an attempt to profit no matter what the markets do. This discussion would be incomplete with some straight talk about risk management. A lot of people go completely broke buying options. They see a chance to make thousand of times their money and lose sight of the fact there is a non zero chance to lose their entire debit. I have three strategies to protect myself from losses.
Step one is diversification. You don’t want to trade just one option at a time. Any single stock can go anywhere in a short period of time. I’m currently using one trade that profits if the broad market goes up, one if it goes down, and another if it trades flat. Two of the three trades are also in the money so I have some downside protection if a position starts to move against me. I also trade weekly and spread out my options plays across TIME. Some will expire in a month, some in two, and some even further out. There is always something nearing expiration to harvest.
Step two is position sizing. Part A of that is using a net debit spread instead of a long put or call. This plays both ends against the middle to reduce my debit. Part B is trading only a few thousand per position on a 300,000 main trading portfolio. This becomes a substantial position sizing over time as it is up to 6,000 per week and four weeks in the month. If I think long term volatility is going to be on the rise, I will likely reduce position sizing even further.
Step three is stop losses. Trailing stops make no sense in the case of Bull Call and Bear Put spreads as the maximum return is fixed. For all three spreads, I actually use a hard stop that I define when I open the position. For most positions, I use a 50% hard stop. This limits me to about 1,000 in losses on any given position. Sometimes, like with the THC bear put spread, I’ll only close the long leg and (if the short leg is well out of the money) let the short leg ride. I expect to turn a big loss into a 75 dollar gain on THC this way. The key takeaway is not to sit on your claws and pray when a position triggers your stop.
Devour your prey raptors!