At today’s Mad Hedge Biweekly Strategy Webinar, I received an excellent question: Why is the Vertical Call Debit Spread my favorite trading vehicle?
So let me ask you this: How would you like to play blackjack now that the dealer would bust 90% of the time? What if you played roulette with the assurance that the ball would land on black 90% of the time?
I bet you would be interested….very interested.
I only trade with Vertical Call Debit Spreads in my own personal account. While your broker may be recommend outright options trades to you because that’s where the volume and the commissions are, if he is smart enough, he is almost certainly executing Vertical Call Debit Spreads for his own account.
And let me tell you why.
1) A Vertical Call Debit Spread offers the most favorable risk/reward ratio of any financial instrument among the plethora out there.
2) A Vertical Call Debit Spread allows you to precisely define your risk. You can’t lose any more money that you put up. With naked short puts, for example, which most other newsletters often recommend all day long, your potential losses are unlimited
3) Vertical Call Debit Spreads allow a vast increase in profits compared to outright stocks, potentially 10X-100X. You can get a claim on $1 million worth of stock for literally only $10,000, not bad when you know the direction. Customers of mine who are nailing 1,000%-2,000% returns in a year, and I get a few every year, are executing very deep out-of-the-money Vertical Call Debit Spread LEAPS.
4) The liquidity for Vertical Call Debit Spreads is enormous for the most popular stocks, like Nvidia (NVDA) and Tesla (TSLA), with exercise values of the options more than the underlying stocks.
5) Vertical Call Debit Spreads allow you to specifically target a share price trading range (very deep in-the-money) that has the highest probability of taking place.
6) The day-to-day volatility of Vertical Call Debit Spread is very low, usually 8% or 9%. That’s because you are long on one option and short on another. This prevents traders from selling bottoms and buying tops, always fatal mistakes. When people ask me what I do for a living, I tell them I stop people from selling market bottoms and buying market tops.
7) When you have a seasoned war horse like me with 55 years of trading experience making your stock picks, Vertical Call Debit Spreads become a total no-brainer. This is why my Trade Alert service is up 68% this year, almost triple the S&P 500 (SPY).
8) Vertical Call Debit Spreads hit their maximum profit whether markets go up, sideways, or down small. It’s only the surprise out of the blue, down moves are large, triggered by black swans, that lose us money and those we stop out of immediately.
9) A Vertical Call Debit Spread benefits enormously from time decay. That is how they hit maximum profits when the underlying stock is unchanged. It gives you a cushion against mistakes and bad stock calls. That’s why I focus on the front-month expirations where time decay is accelerated.
10) Vertical Call Debit Spreads have a built-in short volatility element. If you buy a Vertical Call Debit Spread with a Volatility Index at $24, and it then drops to $14, you make a lot of money. Over the years, I have found that it is almost impossible to lose money with Vertical Call Debit Spreads when the Volatility Index is over $30.
11) OK, I thought of one more reason. Vertical Call Debit Spreads are much cheaper than outright options. That’s because you are buying one option and then receive the proceeds from selling short another option, which cuts the price by two-thirds. That lets you triple your size compared to an outright option. Triple the size, and you triple the profits.
Given all this, I think it’s time for all of you to undergo a refresher course on how to most efficiently play the market with Vertical Call Debit Spreads.
Most investors make the mistake of investing in positions that have only a 50/50 chance of success or less. They’d do better with a coin toss.
The most experienced hedge fund traders find positions that have a 90% chance of success and then leverage up on those trades. Stop out of the losers quickly, and you have an approach that will make you well into double digits, year in and year out, whether markets go up, down, or sideways.
For those readers looking to improve their trading results and create the unfair advantage they deserve, I have posted a training video on How to Execute a Vertical Bull Call Spread.
This is a matched pair of positions in the options market that will be profitable when the underlying security goes up, sideways, or down small in price over a limited period of time.
It is the perfect position to have on board during markets that have declining or low volatility, much like we have experienced in for most of the last several years and will almost certainly see again.
I have strapped on quite a few of these babies across many asset classes, and they are a major reason why I am up so much this year.
To understand this trade, I will use the example of Apple trade, which most people own and know well.
On October 8, 2018, I sent out a Trade Alert by text messages and email that said the following:
BUY the Apple (AAPL) November 2018 $180-$190 in-the-money vertical BULL CALL debit spread at $8.80 or best
At the time, Apple shares were trading at $216.17. To accomplish this, they had to execute the following trades:
Buy 11 November 2018 (AAPL) $180 calls at….…….…$38.00
Sell short 11 November 2018 (AAPL) $190 calls at…..$29.20
Net Cost:…………………….……….....……...........…….….....$8.80
A screenshot of my own trading platform is below:
This gets traders into the position at $8.80, which costs them $9,680 ($8.80 per option X 100 shares per option X 11 contracts).
The vertical part of the description of this trade refers to the fact that both options have the same underlying security (AAPL), the same expiration date (November 16, 2018), and only different strike prices ($180 and $190, or a “spread”).
“Bull” (as opposed to “Bear”) means you receive the maximum profit in a rising market as opposed to a falling one.
“Debit” refers to the fact that you have to pay money to obtain this position rather than receive a credit.
The maximum potential profit can be calculated as follows:
+$190.00 Upper strike price
-$180.00 Lower strike price
+$10.00 Maximum Potential Profit at expiration
Another way of explaining this is that the call spread you bought for $8.80 is worth $10.00 at expiration on November 16, giving you a total return of 13.63% in 27 trading days. Not bad!
The great thing about these positions is that your risk is defined. You can’t lose any more than the $9,680 you put up.
If Apple goes bankrupt, we get a flash crash, or suffer another 9/11 type event, you will never get a margin call from your broker in the middle of the night asking for more money. This is why hedge funds like vertical bull call spreads so much.
As long as Apple traded at or above $190 on the November 16 expiration date, you will make a profit on this trade.
As it turns out, my take on Apple shares proved dead on, and the shares rose to $222.22, or a healthy $32 above my upper strike.
The total profit on the trade came to:
($10.00 expiration - $8.80 cost) = $1.20
($1.20 profit X 100 shares per contract X 11 contracts) = $1,320.
To summarize all of this, you buy low and sell high. Everyone talks about it, but very few actually do it.
Occasionally, Vertical Bull Call debit Spreads don’t work, and the wheels fall off. As hard as it may be to believe, I am not infallible.
So if I’m wrong and I tell you to buy a vertical bull call spread, and the shares fall not a little, but a LOT, you will lose money. On those rare cases when that happens (about 10% of the time), I’ll shoot out a Trade Alert to you with STOP-LOSS instructions before the damage gets out of control.
I start looking at a stop loss when the deficit hit 10% of the size of the position or 1% of the total capital in my trading account. It’s easier to dig yourself out of a small hole than a big one.
And why do I execute Vertical Call Debit Spreads rather than Vertical Call Debit Spreads like most professionals do? Because Vertical Call Debit Spreads are easier for beginners to understand.
To watch the video edition of How to Execute a Vertical Bull Call Spread, complete with more detailed instructions on how to execute the position with your own online platform, please click here.
Good luck and good trading.
Vertical Bull Call Spreads Are the Way to Go in a flat to Rising Market
