Day Six Part 2: Ten of the Biggest Mistakes in Option Trading

Failing to Make the LEAP to Long Term Thinking Part Two

A LEAPS debit spread has two forms a calendar spread and a vertical debit spread. It is the vertical spreads which I consider a fantastic tool to add to your options toolbox. For calls you are buying a call option and simultaneously selling a higher strike call option with the same expiration to offset some of the cost, this is also called a bull spread. As the lower strike call will always be more expensive than the higher strike, the net result is a debit. You pay the difference between the two strikes and that amount is your maximum known risk. Debit spreads reduce the volatility compared to buying options. The decrease in volatility works both ways. The spread value will not decline as fast if the stock price falters, but also will not rise as fast in the event of a rally. The objective is for the stock to be above the top leg of the spread, or if puts are used below the bottom leg, as expiration approaches. Be aware that you will also have two different bid/ask prices and two transaction costs.

The three simple rules to help you design winning LEAPS debit spreads.

1. Look for a spread of ten to twenty points between the strike prices, I find 15 works well for most stocks.
2. Aim for a maximum profit of at least 400%
3. Using an options simulator find a spread that has over an 80% probability of success.

A simple rule of thumb for the first two rules is the debit should be 20% of the spread. So if the spread is 10 you want to pay $2, for $15 you’d pay $3. Below is a profit and loss diagram of the trade you’re looking for.

If 80% sounds high to you then consider this. I’m not talking 80% chance of the price being above the higher leg at expiration. It incredibly unlikely you’ll ever find a trade with those odds. You’re looking for a trade which has an 80% probability of the spread doubling some time during the option’s life.

If you find these trades then you need to guard against another danger. Due to the high probability of your spread doubling some time during the trade you may grow overconfident. The danger is you’ll be so confident that you’ll let profits slip right through your fingers. The easiest way to improve your results is to sell half your position if the spread doubles and let the rest ride with a trailing stop. In stock investing I am not a fan of trailing stops or selling my winners, the key difference with options is time. With time working against you trailing stops and locking in profits are sensible tools to ensure your confidence doesn’t cost you. The easiest way to keep this in mind is that you entering a trade with 80% probability of success at some time during the trade, but which may well have less than 50% probability of success at expiration.

More on Using Leaps Options for Long term profits.

Both these guys are trying to get you to subscribe to their newsletters, I don’t recommend them but they have some examples and their free information is worth checking out.

• By Jeff Carter
• By Ken Trester
• Numa.com has the following to say on Bull Spreads

Strategy View Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit, OR Put option is bought with a stike of a and another put sold with a strike of b, producing a net initial credit. Upside Potential Limited in both cases - Calls: difference between strikes minus initial debit Puts: net initial credit Maximum profit if market at expiry is above the higher strike. Downside Risk Limited in both cases - Calls: net initial debit Puts: difference between strikes minus initial credit Maximum loss if at expiry market is below the lower strike. Margin Possibility for margin requirements to be off-set. Read Part One…