No one likes a good old fashioned more than me, but cocktails are not what we are talking about here. Sometimes as option traders we try to get too fancy, and we get caught up in high-probability trade scenarios like out-of-the-money credit spreads. But many times, a bullish or bearish setup warrants a vertical debit spread. Let’s look at a recent example from MTM’s Group Coaching class.

BABA Example

Recently, Alibaba Group Holdings Ltd. (BABA) gapped higher, just below the $100. It tested that level and then pulled back a tad before moving above the $100 mark about an hour after the open. And it eventually closed well above it as seen below.

When it surged through that $100 mark, we noted in class that it was a bullish trigger. As an option trader you have several options (no pun intended). Many option traders would have elected to sell a bull put spread below the $100 level. This would result in a high-probability trade since the stock could move higher, trade sideways and even drop somewhat in price, and a profit could be realized. These situations result in a not so favorable risk/reward scenario.

Bull Call

In class we decided to take a more directional approach and buy a bull call spread. The stock was above its 50-day and 200-day moving averages and now above some psychological resistance at $100. In fact, it did not have any immediate resistance to possibly keep it from moving higher. We entered the bull call spread seen below when the stock was just above $100.

The Jan-20 100/105 call spread was initiated for a cost of 1.94, which was the total risk on the position suffered if BABA was at $100 or lower at expiration. Max profit at expiration was 3.06 (5 (diff I strikes) – 1.94 (cost)). The next day, the stock flurried higher and closed at $104.58. The position was now up 0.79 ($79 in real terms) (2.73 – 1.94) as seen below.

Not too bad of a return in one day, right? By comparison, an OTM credit spread would not have been able to deliver that type of profit based on its risk/reward.

Give Them a Chance

Many option traders will think of credit spreads first because of the probability of the trade. But if you are more confident about a directional movement, a vertical debit can net you greater profits with less overall risk. Good luck!

John Kmiecik, Market Taker Mentoring