Today on Know Your Options, Liz & Jenny talk all about debit spreads. Although they don't trade them frequently, they like the fact that if they were directional they could use this strategy that requires significantly less capital than owning or shorting the stock. Find out how they set up debit spreads here!

Jenny: Hi, welcome back to the heavy metal version of Know Your Options.
Liz: This is what Jenny listens to in the car on the way to and from work every day.
Jenny: Where's Alex? What's going on with the sound? What's with the music?
Liz: He wants us to have a cutting edge today, so we will for Know Your Options.
Jenny: That was crazy! This is Know Your Options. A hot topic recently, as Liz said, is debit spreads. We're going to talk about them today.
Liz: So, we're going to give you how we use, what we do, and how you will rarely see us trade debit spreads.
Jenny: We don't. We can say this over and over and over and over. We do not like to be directional. We don't like to say "this is going up" or "this is going down" because who knows? Who knows? Certainly, there are products that we like, and we say "We like this product." And, like Liz says, she likes Lululemon. She doesn't mind owning the stock. But-
Liz: There's still a better way.
Jenny: Yeah … Debit spreads are for people who want to make a directional play. That's it. If you want to make a directional play in something and tie up less capital than trading the stock, or be able to make the down side directional play like shorting the stock and make it allowable in an IRA, a debit spread is your go-to strategy.
Liz: We're going to set up a debit spread, and why, because debit spreads are exactly as … Debit spreads can use any strikes, but we set them up in a proper way. So, if you are using debit spreads, set them up properly. Instead of just going out and saying, "Well, instead of selling this, I'll flip the cards over and then buy the debit spread." Debit spreads are all about strike selection. And they can be used. They have their time and their place. If somebody doesn't want the capital at use to buying or selling stock … Because the way we set up debit spreads, you will have the odds of buying or selling that stock, you're going to be using less capital, and giving yourself a baby bit of extrinsic value. The way we set them up, they will have the same directional parameters as buying or selling a stock.
Jenny: So, when we trade debit spreads, we always trade them wrapped around the underlying and pay about half the width of the debit spread. This is how we use debit spreads-
Liz: Wrapped around the at the monies.
Jenny: … Wrapped around the at the monies. And if we're buying a call debit spread that's a buller's trade; if we're buying a put debit spread, that's a bear's trade. This is what we use debit spreads for: wrapping it around where the stock is trading.
Liz: Never, never does that veer. This is the one thing that we want to say here, is when we say debit spread, if you're talking how we trade debit spread, it is always wrapped around the at the monies. That does not veer.
Jenny: That does not veer. Right. That's always wrapped around the at the monies if we're trading a debit spread. We are not going to go out of the money and take a shot and but a debit spread where the stock as to go up to that point. We're not doing debit spreads like that. When we buy a debit spread, it's worth about half the width of the spread, and so that is always go to be wrapped around the underlying price.
Liz: Right
Jenny: Okay, so, we are going to go to the platform, and we are using SPY just because it is an easy product to use for our example. We have no directional assumption in here. We are placing a debit spread for an example only. And we'll do call and put.
Liz: Right, exactly. In this particular example, we're going to put on a call debit spread, and we're going to put on a put debit spread. So, if somebody wanted to buy SPY or sell SPY, in your IRA, say, instead of using the $208 to buy it, or $208 to sell it, we're going to show you what you can do.
Jenny: Right, okay.
Liz: Now, high volatility, low volatility … It doesn't matter what the volatility is in this. We typically don't do this unless we have a severe directional assumption in product that we think is going to be instant gratification.
Jenny: It's more instant gratification than selling an out of money credit spread and waiting that time decay to come out of it.
Liz: But it also depends on how wide you make it and how deep in the money your long is.
Jenny: Right.
Liz: Okay, well, let's give an example before we go into all of the nuances. Bullish or bearish?
Jenny: Well, let's say I'm bullish in SPY and I don't want to spend the money buying the stock … I'm going to buy a call debit spread in stead.
Liz: Okay, so buying a call debit spread … We know the stock is buying for $208. I would be buying an in the money option that the strike selection is wrapped around. So, if I'm buying an in the money option, I'm selling an out of the money option. So, I'm going to go in the calls and buy an option.
Jenny: And, if I'm trying to simulate a long stock option, I'm going to make this a little bit wider. Me, personally, if I'm trying to simulate a long stock option, I'm going to make this a little wider.
Liz: Perfect.
Jenny: So, let's say we do $10 wide. If it's trading $208, we'll go $% down and $5 up.
Liz: Now, just because Jenny is saying she's going $10 wide, let's talk about this. I know, for a fact, that a $10 wide debit spread is going to be about $5. And, so, you're going to be risking $500 to make a directional assumption.
Jenny: So, if I buy the $203, and I go $10 up, and I sell the $213 …
Liz: We have to see if it works.
Jenny: Let's see if this works … $563.
Liz: $563 … You bought the $203 … No, I don't think so.
Jenny: So, why Liz is saying this doesn't work is we look at our break even … Is our break even … If I'm bullish and putting on a bullish debit spread, I don't want SPY to have to go up to make money. And here, let's look at our break even.
Liz: No, pull it up. You don't even need to do the math. And this is what's great is lock it, hit confirm and send, and see where the break even on your product is!
Jenny: $208.63, and it's trading $208.28, so that means SPY, just to break even, has to go up. I don't want to put on a bullish trade and the product has to go up just for me to make money.
Liz: Well, and guess what? Because, if you adjust your strikes, you can change where your break even is, and even keep similar risk parameters.
Jenny: We want our break even to be less than the underlying price. So then, if I want to keep the $10 wide, let me just move these strikes a little bit. Let's see how the $204, $214 is. Or-
Liz: Go the other way. Go the other way.
Jenny: I have to go down. Go the other way. Let's see the $202, $212. … $202, $212 … We're paying $622, but let's take a look at our break even.
Liz: I think we have a winner … So, you're paying $622. So we understand it's a little bit more than where it is. But, what happens here? Now it becomes a trading vehicle where you didn't pay more. You did not give up anything . You didn't pay more, or this doesn't need to move in your direction to make money. So, look at your break even. Your break even in $208.22. It's trading $208.28. Couple pennies, but it's better than giving up that 50 cents that we did in the original!
Jenny: If we're using this as a stock replacement, and we want to get long this stock instead of that, we're going to use a debit spread. Then you don't want your break even to be worse than if you went out and bought the stock.
Liz: Right. You do not want your break even to be worse, because that's what options allow you to do. Now, we realize right here, we're not saying you're making anything. This is 8 cents away.
Jenny: But, if you buy the stock, you need it to go up to make money. If you buy this debit spread, you need it to go up to make money.
Liz: Exactly. And this is 1 for 1. These are going to be wrapped around 50/50 odds. Very similar scenario. You can find it where we're getting 50 cents, 60 cents, but make sure you're not giving it up. So, what we want to say here is, it's okay if it's right there as far as the price goes. We're not doing this to say, "Hey, we're going to make this 8 cents!", because this is an arbitrary situation. But, what we want to make sure is we're not paying too much for what we're trying to synthetically do.
Jenny: So, debit spreads are short term directional plays. When I say short term, they're not daily. Some people will be watching charts and making daily plays, like "Oh, I think this is going to go up today." Using these options … this isn't a daily, you're trying to get in and out of daily moves. You''re better off trading the stock not these debit spreads.
Liz: Right. I mean, that being said, I know people use the weeklies to synthetically say that as if they think it's going to be up this week or down this week, they will use the weekly options in the debit spreads. And they have their time and their place. I, personally, don't trade like that.
Jenny: I don't trade like that either, but if have … Like, this is a January expiration. If you think SPY is going up between now and January, and you want to make a trade like this, here's how you can do it with a debit spread. This is not how I trade, and you will never see me doing these.
Liz: So, now, in the effort of fairness, let's show the exact example on a short side. So, people have directional assumptions to the down side all the time, and, a lot of times, they are trading in an account that do not allow you to sell the stock short. Say you're in an IRA, and you have a bearish assumption on any product, whether or not the IV rank is high or low, you can't sell calls. But, what you can do-
Jenny: You can't sell calls, and you can't sell stock.
Liz: You can't sell stock, but what you can do is buy a put debit spread as wide as you want to make it, and synthetically replicate a short stock position.
Jenny: So, it's just the opposite. It's just the opposite. And I should've went to the Analyze tab so people could see … But it's just the opposite. These are defined risk trades. So, with a debit spread, what you paid for the trade is your risk on the trade. You'll never lose more than what you pay for it. If you're buying a call spread, or you're buying a put spread, you're risk is what you pay for it.
Liz: It's also your capital required. So, if somebody is having a directional assumption, and say … In that particular example with even the call side, we paid $6 or something, right? So …
Jenny: And it was $10 wide, so the most it could be worth is $10. So, realize what you can make on this.
Liz: Right. You're only going to make 300 and some odd dollars, but you're only putting up $600 to do it. So, in this particular example, if you were going to go out and buy SPY, you're putting up a lot more capital … Where do you expect it to go? I mean to get that $300 out of it, you're still putting up thousands of dollars.
Jenny: Exactly. So, it can give you the same results of having a long stock or short stock position with tying up a lot less capital … I was thinking of these today. Tom and Tony were talking about Southwest Airlines and trading LOVE. I don't know what they were looking at, but said something about the money in the calls wasn't worth it. They would rather sell the stock than sell the calls. And I also though, you can also put debit spread.
Liz: A large, put debit spread. So, in the essence of time … I think we have a couple minutes left. Let's try to pull up a put debit spread.
Jenny: Okay, and we'll make this one narrower, because you can make it as wide or as narrow as you want to. Let's make this one narrower. If it's trading $208, and we wrap it around $208 …
Liz: Do a $5 wide.
Jenny: Let's see …
Liz: Or a $4. I'm sorry, you can do a $5 wide.
Jenny: Sure. So, if we buy the $211 … And we sell the $206 … $5 wide … Should be trading right around $250 … This is bearish. So now, we don't want our break even to be below the stock price.
Liz: We need it to be above it. And it is.
Jenny: And it is.
Liz: So, here-
Jenny: Right.
Liz: So, now, this gives a little bit of wiggle room.
Jenny: A little bit of room. So, you buy this put debit spread; it's a bearish trade. If SPY goes down, this trade will make money, but if it even goes up, you have a little bit of room. If it closes at expiration at $208.61, you're not going to lose anything on this. So, you have a little bit of room. SPY has 30 cents in room to go up, and you won't lose money on this trade.
Liz: And in this particular example, it came up our first try with the $5 wide, we had some extrinsic value wrapped around these. You know what? You can adjust your strikes, like Jenny had said. If you pull it up, and your product has to move in your direction in order for you to not lose money, then play with your strikes.
Jenny: Play with your strikes. So-
Liz: Because the wrapped around the monies will always kind of be right around there.
Jenny: Yes, yes. So, we are almost out of time. I want to go over a few rules of debit spreads.
Wrap them around the underlying price. Make them as wide or as narrow as you want to risk.
Liz: And debit spreads … The only risk you have is what you pay for them.
Jenny: And, you should realize the width of the spread is the most it can be worth. So, if you're doing a $5 wide spread, you don't want to pay close to $5. If you're doing a $10 wide spread, you don't want to pay close to $10. You want to pay about half of the width of the spread.
Liz: There's a reason you want it to be around 50% because of that. You need to be able to make some money. You're going to look at it on paper and say, "Oh, this is great. I'm going to pay $6!" And only make $7.
Jenny: Right.
Liz: The other thing is, it's a huge capital savings when you look at it for the return on capital. But realize it's 50/50 odds.
Jenny: It's just like trading the stock. They're 50/50 odds. But, if there's something you want to make a directional play in, and the volatility is not there to sell options, it is something that people choose. It's a strategy that people choose.
Liz: Right, so we're going to take a quick break and come back with "Trade Small, Trade Often."
Jenny: So, stay tuned. You're watching the Liz and Jenny show.