- 2001: Volume 10, No. 2 Puts & Calls: The Walk-Away Strategy: Debit Spreads Revisited

It is often said that only those who trade with a plan will thrive in the stock market. But more important than having a plan is actually staying with it. This means that when the appropriate signals you have predetermined to execute a trade appear, you heed them, taking profits when they hit your target and sticking to your stringent stop losses. Easy, right? Well, if you’re like most of us, it’s much easier said than done. But we have to start somewhere, and the first thing we need is an instrument that provides little room for cheating our plan. This instrument should not only take our emotions out of the play, but also have the ability to provide us with a consistent framework from which we can know our exact risk and reward. So what strategy can give us all that? The ol’ options debit spread, that’s what. Now, before you start throwing tomatoes at me while yelling that you already know all about them, indulge me for a moment. I’d like to share with you a unique way of looking at them. Maybe, just maybe, you will never look at long calls or puts the same again. I call this strategy the Walk-Away debit spread.

Suppose that on any given long option play, your trading plan is to set a profit target of 100 percent and a stop loss of -50 percent. You have essentially set up a 1:2 risk/reward ratio. On a $2 play, you are willing to lose $1 to make $2. But what if the stock gaps down the morning after you purchase the option and you wake up to an option that’s only worth 25 cents? (Not uncommon in today’s environment, wouldn’t you say?) You planned the trade perfectly, waited for just the right entry point and bought it when your indicators told you everything was a go. How could it fail? Who knows. But one thing is for certain: a debit spread properly executed will never allow for this to happen again.

To enter a Walk-Away debit spread, you simply create a play using a debit spread with a net debit equivalent to the original stop loss you would normally set on a long play consisting of just buying calls or puts. For example, suppose you are planning to buy an option for $5 and have a mental stop to sell the option if it goes to $3. If you are satisfied with a maximum loss of $2 anyway, then consider hedging that $5 option with the sale of another option further out-of-the-money that that will credit you the same $3. Now you are in the same play for only $2 instead of $5 (5-3=2). So, not only is it still possible to achieve your profit target (albeit at a slower pace), you also cannot lose any more than your original stop of $2 since that is the entire cost of the play. Not even that ego of yours will need to work very hard at guessing where an ornery stock will stop sucking away your profits. The end result is that you won’t have to take a chance on losing more than your intended stop because your maximum loss is set in stone as the net debit. I like to think of this as the net that breaks my fall in case I miscalculated my trapeze partner (the underlying stock). I know I will fall, but I won’t hit the ground with quite as loud a thud.

There are two kinds of debit spreads: bull call spreads and bear put spreads. A bull call spread is created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. A bear put spread consists of purchasing a higher strike put and selling a lower strike put with identical expiration dates. In both strategies, the maximum risk is limited to the net debit of the options and the maximum profit is limited to the difference in strike prices minus the net debit. The breakeven for the bull call spread is calculated by adding the net debit to the long strike price; while the breakeven on a bear put spread is calculated by subtracting the net debit from the long strike price.

Let's take a look at an example of a bear put spread. Say you think high PE stocks in the current market environment will continue to sell off, and Ciena (CIEN), with a PE well above 200, is likely to be one of them. On February 22, 2001, Ciena is trading around $70. You check the price of the March 70 put and see that it costs $8.13. If you buy it, you intend on setting a stop loss of $2.50 to sell the put if it hits $5.63. But before you go ahead with the play, you wisely realize that a quick view of the daily chart (see Figure 1) indicates some pretty large swings in the stock. With that knowledge, you’re inclined to check the recent implied volatility on the stock by using the free charts on the Platinum site at Optionetics.com (see Figure 2).

Figure 1:

Figure 2:

For the last three months, the volatility has remained pretty high. On this day, however, it rests on the lower end of its most recent range just above 100 percent. Knowing this, you realize that though you may be able to buy puts at a fairer value than in recent months, it’s still very expensive. The stock is going to have to make some pretty large moves in a short amount of time for the put to reach your profit target. And with the volatility being pretty high, the odds that you’ll get stopped out first are pretty good.

Enter the Walk-Away debit spread. Being the smart cookie you are, you check to see how much the March 65 put is selling for to put on a hedge. Lo and behold, it’s selling for $5.63. If you set up a debit spread by selling the March 65 put against the March 70 put, the net debit to your account is $2.50, the same $2.50 you were willing to sacrifice if you got stopped out on the long play. Only now, you can "walk away" from the play, knowing that you can’t lose any more than that and a breakeven of $67.50 (70 - 2.50). Since the maximum profit and maximum loss is $2.50, you’ve got a 1:1 risk/reward ratio. I don’t know about you, but I’ll take those odds instead of a good chance for a total loss any day.

As with everything sacred, there’s a caveat. You don’t have unlimited profit potential in a debit spread like you would if you just buy calls or puts without the hedge, but how often does that really happen these days anyway? How many more times are you going to tell yourself, "this one is it" before you run your account dry, betting on home runs? You may as well run to the casino and throw it all on the roulette wheel, where you’ll probably have more fun and better odds anyway. If you really feel that strongly about the stock’s direction, take the profit on the debit spread and put on another one at higher strike prices. Keep repeating this until the play turns. That’s all there is to it!

For kicks, I thought I would list the benefits of this strategy. As you read them, ask yourself if your trading plan works this well.

The Walk-Away Debit Spread Advantage

1. You never lose more than the amount of your net debit, which you predetermine.
2. You can relax and let the play work itself out without having to watch it minute by minute, thus giving you a life! (Hence, "walk away" from the play.)
3. Discipline is forced because you follow a plan—you’re guaranteed not to lose more than your stop loss, and you won’t exit the play prematurely by being "shaken out."
4. It doubles as a tool for instituting an account management system in your trading plan.
5. During slumps, you see the return of your profit rhythm.
6. You sleep better at night.

Do you see how this can be a nice, structured change, as opposed to the chaotic trading style of buy and hope? The good thing about debit spreads is that they offer a safer alternative for aggressive traders who must trade directionally. They can be put on during calm periods or volatile ones. Play them on either exciting stocks, like Juniper Networks (JNPR), or slow and steady ones, like Maytag (MYG). In any case, plays that offer purely definable risks and rewards will go a long way in your trading plan toward consistent profits. The rewards may not come as quickly, but neither will the losses. And with that, your precious trading capital will give you its humble thanks.

Michael Bennett is a staff writer and trading strategist for Optionetics.com. He can be reached at mbennett@optionetics.com.