The stock market sometimes becomes a little temperamental at times. That is just when a well thought out plan and the best way to maximize your investment or trading dollars is most needed. Everyone of us has been the buyer of that high flying call option or the purchaser of that put option of the next World Com. Sometimes we even hit a home run, but more often than not, we go down in a burning blaze of glory. This of course makes great theatre, but it doesn't bode very well for stock option purchases. The use of the Debit spread is a very effective way to solve two constant problems that option students seemed to be always faced with.
1. Deciding which trade to make when you can only make one trade.
Even though the use of the Debit Spread limits the maximum amount that you can make, on the upside it offers other attractive advantages, especially for the newer option enthusiast, and one of those advantages, is it offers you the chance to solve both of the two problems mentioned above.
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Let's say that you were slightly bullish (remember earlier articles regarding what is your intent before you trade) and you felt that the Nasdaq 100 - QQQ might make a little move here, but you were not sure, but either your technical analysis or your gut instinct felt that a small QQQ move was in the cards. However, you also feel that you would like to purchase a few puts a few months out on GM, because you feel their earnings were going to take a hit late next quarter. You really would like to do both, but your capital outlay is such that you only have the capital to do 1 of these trades in the amount of contracts you desire. What can you do?
Let's fully understand the dilemma by examining some real numbers.
Let's say you wanted to buy 10 contracts of the QQQ JULY 35 calls at 1.80 with the QQQ index trading at 36.48 and you also wanted to purchase 10 contracts of the GM SEPT 25 puts at a cost of 3.50 a contract
But you have a small problem. You only have about $3,500. Which is enough to purchase 10 contracts of one or the other. I know what you are going to say! Why not purchase 5 of each. Good point! except remember the concept of. "WHAT IS THE INTENT OF YOUR TRADE"? By thinking about cutting back the number of contracts you have ignored the intent of your trade. THIS IS ALWAYS FOREMOST TO REMEMBER. So, we can buy either 10 calls of the QQQ or 10 Puts of GM. We can spend either $1,800 on the QQQ or $3,500 on the GM. But not $5,300. What shall we do? What can we do?
We can utilize the Debit Credit Spread with both the QQQ and GM and have an opportunity to participant in both the trades. Here is how.
If we purchased just LONG calls on both the QQQ and the GM, our net cost and positions would be as follows: