How To Use A Debit Spread Option Strategy

| August 1, 2008 | 0 Comments

I can’t pass up a good deal.  As a matter of fact, I buy the Sunday paper every week for the coupons.  I’m not afraid to admit it.  I seem to have a nose for a good deal.  I can find bargains anywhere, its just as easy in Brooks Brothers as it is the Safeway produce department.

I’ve saved a great deal of money in my life.

A few years back however, I learned a technique that’s saved me thousands of dollars when buying options.  I learned a secret way to buy options at a discount.

I’m going to share that secret with you today.

One of the reasons I like trading options is because they’re cheap.  But, sometimes option prices are higher than I’d like.  If you’ve ever traded options you know what I’m talking about.  The more volatile the stock, the higher the option price.

In the last few months, the two hot sectors are energy and financials. Obviously one’s been going up and the other’s been going down.  As the volatility in those industries increased the price of the options also increased.

Take for example Wells Fargo (WFC).

Wells has suffered the same fate as all the other banks . . . a falling stock price.  Now the big fear is the credit crisis will spread to other areas of their business.  Investors wanting to protect themselves from a falling stock price would purchase put options.

But right now those options are expensive.  Today, Wells is trading around $30.  An October $25 put would cost you a whopping $1.75 per contract . . . or $175.  Compare that with Microsoft (MSFT) which is trading around $25.  You can buy an October $20 put (note the same amount of time and about the same price difference of $5) and that option would cost you $0.17 . . . or $17 per contract.  That’s about 10% of the price of the Wells Fargo put!

See what I mean by being expensive?

So what do we do?

We buy a debit spread.  Back to the Wells Fargo example.  The October $25 put options are selling for $1.75.  The October $20 put options are trading at $0.75.  So buy one and sell the other.  By buying the $25 put option for $1.75 and selling at the same time the $20 put option for $.75 you’ve cut your cash outlay by 42%.

42% is not a bad discount if you ask me.

Remember, we’re buying put options because we expecting the stock to fall.  If it goes up in price our put options expire worthless.  But if the stock moves down – Watch Out!

As the stock falls we start making money.  As a matter of fact, at $24 we break even on the trade and we make money all the way down to $20!  Let’s say the stock falls to $20.  That means our put option we bought for a $1 is now worth $5.  That’s a 400% gain!

Not bad for a few months work.

And if the stock keeps falling below $20, every penny made in the $25 put is offset by our sale of the $20 put.  But remember, at that point you’ve made 400% on your money.  Your only loss is giving up a little bit of additional profit.

Remember, this is an advanced option strategy.  Don’t make trades like this unless you understand all of the risks and rewards.

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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