Written by A.J. Brown

OTM Near-Term Vertical Debit Spreads

As we mentioned a week ago, the market has been extremely volatile. And extreme volatility exposes open positions to increased risk.

The catch?

If you open and close too many positions in a single week, you will be tagged as a pattern day trader, and forced to comply with a set of complex and onerous rules.

To reduce our exposure, increase our probability of making a profitable trade, and avoid being flagged as a pattern day trader, we’ve been using out-of-the-money near-term vertical debit spreads. What this means is that we’ve been leaving our positions open overnight instead of closing them intraday.

A vertical debit spread is like a cheap insurance policy to protect you in case a stock gaps up or down.

Here’s how it works…

First, for this strategy, you want to get out-of-the-money near-term vertical debit spreads. Basically, if you are in a long call position that you plan to hold overnight or over a weekend / holiday, in the last minutes of the trading session,  you go long a vertical bear spread.  And, conversely, if you are in a long put position that you plan to hold overnight or over a weekend / holiday, in the last minutes of the trading session, you go long a vertical bull spread.

The farther you setup your vertical debit spread from where the price the underlying stock closes the trading session at, the more inexpensive the strategy and also the greater the pay-out when and if the strategy is satisfied (the vertical spread becomes in-the-money).  The trade-off is, the farther away we setup the vertical spread from the underlying stock price at close, the more gap and price movement you’ll need to satisfy the strategy.

A good analogy is the trade off your make when you purchase homeowners insurance.  You can get a cheaper insurance policy, if the insurance has a higher deductible before it kicks in.  The difference in price between a $1,000 and a $10,000 deductible home owners policy can be large.  However, when it comes to the payout you received when your $250,000 house burns to the grown, the deductible becomes insignificant.

In effect, the strategy is a form of low-price insurance against opening gaps that go against us.

In a very volatile market, where an underlying stock can significantly gap up or down at open, this strategy can make you as much as ten to twenty times your investment.  That is even after unloading your long position for whatever you can get.  This gain is when things turn sour for your long position.  Talk about quickly turning lemons into lemonade!

If the stock doesn’t gap, and the price is trending horizontal, then you can keep your vertical debit spread in place. Or, if you’d rather, you can unwind them, losing only pennies.  In effect, you are cashing in your”insurance policy.”

If the stock gaps in the direction of you long position, you can unwind this trade making back what you can.  The gains you make on your long position appreciation will more than cover the loss for using this strategy.

During the trading day, you can use a standard stop-loss strategy on your long position and reserve these out-of-the-money near-term vertical debit spreads for overnight insurance.

Out-of-the-money near-term vertical debit spreads are easy and generally require very little justification, if any, to your broker, to use.

Okay, here’s an example if their use:

As I write this, the ticker QQQQ is currently trading at about $31 bucks and is trending down. If I was in a long put position and I buy an OTM near-term $32-$33 bull call spread as an “insurance policy” now, I would pay and additional $0.28.

The next morning, if their was a stock gap up on open, I could easily double my money or more on the near-term vertical debit spread — turning $0.28 into close to $1.00, depending on how close we are to expiration.

Basically, I’m positioned to profit no matter which way the stock price swings. And if the stock continues in a horizontal channel, I can leave the vertical debit spread in place for a few days.

After a few days, if the stock hasn’t gapped up or down, we can sell our options back and recover 90-95% of our investment, possibly more.

With such little money at risk, you can afford to use this stratetgy multiple times until it works. Because not every case will produce a profit for you. But those that do will more than pay for your mediocre trades.

I’ve personally been using out-of-the-money near-term vertical debit spreads with good success. Almost daily I’ve been making 30-120% gains on small investments. Not bad for such a simple little strategy.

Best regards always,

A.J. Brown

9 Responses to “OTM Near-Term Vertical Debit Spreads”

  1. BobM @ 10:51 am:

    AJ, thanks for the idea. I have been thinking about using options vice buying stocks directly so I think I will practice this on a little “play” money first. I want to get the hang of securing options and selling them. bm

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  2. Philip @ 11:18 am:

    Thanks AJ. I know you talked about this on Monday’s webinar and I was wairing to listen to it again because I missed about fifteen minutes of the webinar. But this is really very helpful.

    Thanks again.

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  3. scott @ 11:23 am:

    AJ

    Great article

    I think I sent you a PM about this yesterday in fact.

    scott

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  4. Mike @ 12:26 am:

    This sounds like creating a strangle, with puts to profit on the downside and calls (call spread) to profit if stock price goes up.

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  5. Brad @ 8:39 am:

    AJ,
    It makes so much sense to hedge this way in a volatile market. Let’s call it common sense.

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  6. A.J. Brown @ 1:00 pm:

    Hey there!

    I’m so excited. I was meeting last night with my “insiders” club (a group of apprentice program graduates that meet with me to discuss trading trends, our personal portfolios, and what’s working versus what’s not.)

    Together we were reviewing trades in our group log tools and, sure enough, saw quite a few members and current apprentices executing the strategy I wrote about in this blog post. Congratulations every single one of you on your amazing returns!

    I definitely want to recognize our member L.M. for executing this strategy perfectly. Here are his trades:

    ———————————————–

    Long AAPL Oct 110 Call
    Buy to Open @ $1.83 on 10/13
    Sell to Close @ $4.15 on 10/14

    Short AAPL Oct 115 Call
    Sell to Open @ $1.25 on 10/13
    Buy to Close @ 2.01 on 10/14

    Vertical Debit Spread Open price: $0.58
    Vertical Debit Spread Close price: $2.14
    ROIC: 269% <—- Wow!

    ———————————————–

    Long AAPL Oct 110 Put
    Buy to Open @ $1.84 on 10/14
    Sell to Close @ $4.25 on 10/15

    Short AAPL Oct 95 Put
    Sell to Open @ $0.95 on 10/14
    Buy to Close @ $1.81 on 10/15

    Vertical Debit Spread Open price: $0.89
    Vertical Debit Spread Close price: $2.44
    ROIC: 174% <—- Stellar!

    ———————————————–

    Long SPY Oct 91 Put
    Buy to Open @ $1.87 on 10/15
    Sell to Close @ $4.95 on 10/16

    Short SPY Oct 90 Put
    Sell to Open @ $1.51 on 10/15
    Buy to Close @ $3.75 on 10/16

    Vertical Debit Spread Open price: $0.36
    Vertical Debit Spread Close price: $1.20
    ROIC: 233% <—- Fantastic!

    ———————————————–

    The moral of the story is that this strategy works and it works well.

    Is it easy? Yes, very… for those that have the knowledge and understanding.

    Why don’t all investors do it? I honestly don’t know. I would if I were them. Maybe they’re afraid. Maybe they perceive it as complicated. Maybe they just like to throw stones. I’m not sure. But for the type of returns that are possible, I’d put what I think I know aside, step out of my comfort zone, and be open to learn and try something new. Wouldn’t you?

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  7. Sally @ 11:41 am:

    Looks like LM should be very happy! Can you give more detail as to which strike prices were bought and sold for the spreads? You mentioned that we should buy near term options, but how far from price at close of day? Say if the asccending stock closed at $82. Would we buy the Nov 80 Put and sell the Nov 75 Put? Please explain so that I can understand this.

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  8. ralph Conradt @ 12:04 am:

    When I tried to make the play and “SELL TO OPEN” I was not able to do it cause I had insufficient shares. R u perhaps leaving out a crucial bit of info—like you have to actually own the equity?

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  9. A.J. Brown @ 1:16 am:

    Ralph,

    Before you short an option you must be long an option that is on the same underlying stock, first. You must have equal or more contracts long than you intend to short. Also, check with your broker that your brokerage account is endorsed to do vertical spreads. If not, ask your broker to put that endorsement on your account.

    A.J.

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