Debit Spreads May Be The Way To Go Now

Looking for an option trading strategy that’ll work in the current market? Here’s a great article on why debit spreads may be the perfect strategy right now. Check it out and let me know what you think.

With the continued march to a world of sub-20% VIX1 readings, premiums required to purchase out-of-the-money debit spreads have continued to decline.  Couple this lower premium with the almost 6% rise in the S&P 500 Index (SPX) since the start of this new year and you may discover some compelling trading opportunities.

Whether you believe an upside breakout may be coming or you are concerned about a possible retracement in market prices, lower-cost debit spreads may be one way to limit your risk while potentially profiting through a limited-risk limited-reward strategy.

Think about it this way:  if your preferred strategy is to sell out-of-the-money SPY (SPDR S&P 500 ETF) puts as a strategy to gain neutral-to-bullish market exposure, the premium you now receive by selling put options is considerably lower than it was two months ago.2 You either have to sell options with strike prices that are significantly closer to being at-the-money (ATM)3 to receive the same premium, or you have to sell options that are the same distance out-of-the-money for much lower premium.

Is it worth it?  The maximum reward for a short/sold put is limited to the premium collected upfront (while risk is unlimited down to zero).  Perhaps the strategy is still worth it for some traders, but those concerned about the risk/reward of short options might look to the lower-volatility environment for current opportunities that are present in long debit call spreads. It may make some sense, because if options are too cheap to sell, they may be a value to buy.  The risk to buying debit spreads is 100% of the premium paid, while the profit is limited to the difference in the traded options’ strike prices less this premium.

Conversely, if you don’t believe this rally, what could you do?  Well, with the market run-up and the volatility decline, there are symbols on which you can buy debit put spreads that would be in-the-money if the underlying stock retraces back to trading prices just 30 days ago on January 1, 2012.   The prices of these debit put spreads are now lower than they have been in the recent past and may once again provide compelling limited-risk, limited-return trades.

See Option House for the entire article

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