New Option Trader

I’ve been focusing on mastering spreads for a while now because every other strategy is either a combination of spreads a just another type of spread. So, really understanding how spreads work and why is key to understanding all the other strategies.

Now, I know that there are bullish spreads and bearish spreads, and that some are credit spreads and others are debit spreads.  I also know that generally we’re talking about going long with two options in the same month but different strikes.  Or, going short with two options in the same month but two different strikes.

But what I don’t yet feel comfortable with is deciding between a bull call spread or a bull put spread (if I’m bullish that is). Or, if I’m bearish should I go with the bear call spread or the bear put spread?  Also, what are the general rules for what strike to buy, where should the greeks be, and how far/close to expiration I should place the trade???

Here are some of my notes from a recent class about spreads:

What is a spread?
An option strategy where you buy and sell options in a 1:1 ratio — as one trade. It’s a “vertical spread” because the options are spread between two different strike prices.  On the quote board  (back in the olden days) prices would be listed vertically –> hence the term “vertical spread”

Why use a spread?

1. They’re cost effective. Because you’re selling one of the options, it’s offsetting the cost of the one you’re buying and thus reducing the whole cost of the trade.  This is good way to trade the more expensive stocks/options.
2. It’s also good premium collection strategy

Two types:

1. Long vertical spread: call spread  — this will also generate a debit
2. Short vertical spread: sell the put spread  — this will generate a credit

General Rules:

• Buy the options in a spread always in a 1:1 ratio
• Have a directional bias for the stock and a reason for that bias

Construction:

Bull call spread: Buy low, sell high…

• Buy the lower strike call
• Sell the higher strike call

Bull put spread: same thing but with puts

• Buy the lower strike put
• Sell the higher strike put

… just remember BLSH = Buy Low, Sell High    … which sounds like BULLISH

Just started reading, Options Trading 101 by Bill Johnson.  I’ve attended Bill’s classes and recently met him at the Options University Workshop.  Great guy and he has a talent for explaining options in a way that is crystal clear especially for beginners.  The first time I heard him speak I was blown away by how much I had learned in a single class.

I’m only on the first chapter but so far the book is great.  It will partly be a review for me (for stuff I know) and partly help me understand certain things I’m still need to have a better grasp of such as volatility, hedging, and spreads.

Delta
The amount by which the price of an option changes for every dollar move in the underlying instrument.

Yahoo! Options Glossary

Just bought a QQQQ DEC 07 50 call @ 4.92.   Main criteria I used was a delta of .75 or higher seeing that the QQQQs had take a small little dip but overall seem to going up.  I’ve paper traded this strategy before and it worked out really well.

On another note, just heard out that Price Headley is a guest speaker on today’s Think or Swim chat.  The session is titled, “Identifying Technical Turning Points and Key Sector Trends”.

I just closed a bear put spread on Pulte Homes that I opened in Sept.  My thinking at the time was that the stock was in a freefall and the housing market was not going to make a spectacular comeback in a month.  So, I placed a bearish trade that would be profitable if PHM moved anywhere below 15 and reach it’s maximum profit at 12.  I was sure it would hit 12.  I was wrong.  But, it did go down and that’s all I needed.  For a while there I was sure this was a losing trade and a hard lesson learned.  It may not have gone to 12 but it went low enough and since I had held on until expiration day I had the time value to make up most of the profit.

9/10, Bought Bear Put Spread

BUY 4 PHM OCT 07 15P
SELL 4 PHM OCT 07 12.5P
Debit 0.80
Cost of trade:  $320

10/10, Sold Bear Put Spread

SELL 4 PHM OCT 07 15P
BUY 4 PHM OCT 07 12.5P
Credit 1.15

Credit to account:  $460
Profit:  $140, 43.75%

Wow!  Here’s a trade that I’ve been regretting for weeks now because I was sure I’d lose my whole investment — any my trading account isn’t that big!

Instead, I got 43.75% return.  That’s not bad.

So, what did I learn:

• I didn’t really understand the Bear Put Spread strategy.
• Never trade a strategy I don’t understand.
• Options are great, even a small movement can have a great ROI so better to not be gready holding out for the biggest profit possible.
• I’m not a bear but I still need to work on how to trade like one