Although most option traders do not live on buying calls and puts alone, they often forget to look at vertical debit spreads as well. Too many times they go straight for a vertical credit spread. By no means am I implying not to trade vertical credit spreads, but I believe too many traders automatically default to them even when there is a directional bias.

A Quick Example

Let’s say an option trader believes ABC stock will rally over the next month or so. The stock is currently trading at $52. He or she could buy the October 50 call for 5.50. But what if the trader was wrong and ABC traded sideways or dropped in price over the next several weeks or the implied volatility of the option fell? The value or premium of the option would probably be lowered.

An Alternative

Instead of just buying a call, a bull call spread could be implemented by selling a higher strike call against the long call. An October 55 call can be sold for 2.25, which not only lowers the cost and maximum risk on the trade to 3.25 (5.50 – 2.25) but also lowers the position’s exposure to implied volatility changes because the spread’s vega is lower than just the long call by itself. Vega measures the sensitivity of an option's price to a change in implied volatility.
 
As you probably already know, there are plenty of trade-offs when it comes to options trading. This spread lowers the risk, but it also limits potential gains because of the short option. Unlike a long call whose maximum profit is unlimited, no matter how much the stock rises past the short strike maximum profit is capped.

Know Your Greeks

Also, options traders should have a full understanding and be able to compare vega (option's price change given a change in volatility), theta (option's price change given a change in time decay) and delta (option's price change given a change in the underlying) when buying calls and puts outright. Being aware of these greeks will help eliminate buying options with inflated premiums, choosing options with too little time left to expiration and other problems as well.

Finally

This has been a friendly reminder to think about vertical debits instead of vertical credits at times. Long calls and puts should not be discounted either, but there is a time and a place for them too. Trust me, bull calls and bear puts have been game changers for my own options trading.

John Kmiecik, Market Taker Mentoring