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Futures Options Spreads: Why Should You Use Debit or Credit Spreads?

August 2, 2011 by Drew Wilkins| Tips & Strategies

One of the main questions I receive as a broker after presenting a futures option spread to a client is, “Why?” Traders want to know why they should be entering an option spread as opposed to purchasing or selling an option outright.  This article will help to explain the Why behind entering an option spread.

Please click to view the Options and Spreads risk disclosures below.

Why Use Option Spreads?

Purchasing option spreads offer the ability to get involved in markets for less of a premium than if one were to purchase options outright.  This is done by selling an option to help finance the purchase of an option.  This is known as a debit spread.  Option spreads also allow you to collect premium without having to sell a naked option, which carries unlimited risk.  This is done by selling an option and then purchasing an out of the money option to help reduce risk.  This is known as a credit spread.  Let’s take a more in depth look at debit and credit spreads.

Debit Spreads

A Debit Spread is when a Trader purchases an option spread and the premium paid is debited from their account.  This is just like when you use your debit card at the gas station and the cost of gas is debited from your bank account.  Debit spreads offer an opportunity to get involved in the option market for less premium than purchasing an outright option.  If a trader wanted to purchase an at-the-money gold call for September, it would currently cost $3,160.  This might be more than a trader wants to spend to get involved in an option.  However, if the trader has an area he thinks the underlying market will be at expiration, he can use a bull call debit spread to reduce the cost.  If he thinks the underlying futures price will be at 1650 at expiration, he can purchase the 1615/1650 September gold call debit spread for a price of $1,460.  The maximum risk on the trade is the $1,460 paid for the spread.  The maximum profit, therefore, will be the difference between the strike prices minus the cost of the spread, or $2,040.

Credit Spreads

Option spreads also can come in handy when you think a market will not go somewhere.  This is the perfect scenario for a credit spread.  Let’s say a trader thinks the corn market won’t go below $6.50/bu.  He could sell a naked put option at $6.50; however, this carries unlimited risk.  The risk and reward of selling naked options has been characterized as “taking the stairs up and the elevator down,” in reference to account values.  Credit spreads offer a defined risk with the ability to have a play on where you think the market won’t go.  The trader can sell the December 6.50 put for $1800 and also buy the 6.00 put for $900 to help reduce risk.  Then, the trader would collect $900 for the position.  The maximum risk is the change in strike prices minus the premium collected, or $1600.  If the futures price at expiration is above $6.50/bu, the trader will keep the premium initially collected.

Summary

These are just two of the ways traders can use option spreads.  They offer great ways to get involved in the futures options markets with the maximum risk being known.  To learn about these strategies in more depth, check out the following articles:

  • Bull Call Spreads:  An Alternative to Purchasing Calls by Drew Wilkins
  • Bear Put Spreads:  An Alternative to Purchasing Puts by Drew Wilkins
  • Credit Spreads:  Collect Premium while Keeping Your Clothes On by John Payne

Options on Futures Contracts: A Trading Strategy Guide

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Filed Under: Tips & Strategies

About Drew Wilkins

Drew received his B.S. in Agricultural Business from the University of Arkansas. Growing up in Arkansas, he was always familiar with agriculture. However, it was a Futures and Options class in college that sparked his interest in making a career out of the markets. “Learning more about the overall marketplace was fascinating. From hedging to speculating, the futures markets offer a risk management and investment avenue not found anywhere else.”

Since joining Daniels Trading, Drew has helped his many clients navigate the markets. He prides himself in being diverse in his execution abilities. Whether you are looking to enter a multi-leg option spread or enter a market order online, he can help you get it done. Drew knows that not every client is the same. One of the aspects he enjoys most is working with new clients and helping them formulate a plan on how they want to approach the market.

When out of the office, Drew enjoys playing golf, flag football and cheering for the Razorbacks.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.

YOU SHOULD BE AWARE THAT IN THE EVENT YOU LIQUIDATED THE LONG SIDE OF A BULL CALL SPREAD AND STILL MAINTAINED THE SHORT OPTION POSITION, THEN YOUR RISK WOULD BE UNLIMITED.

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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