If you can understand the title you're approved to continue reading this article by AJ Brown from TradingTrainer.com. AJ is really one of the only guys I know who can make something like OTM Near-Term Vertical Debit Spreads an easy topic to understand and execute! Read the below article and also be sure and get AJ's Options Trading Courses as I made him promise to give it to Trader's Blog readers for free! He told me he was impressed with Trader's Blog readers and really wants you to ask him some tough questions...don't let him down!
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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:
Lets say 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
TradingTrainer.com
Also please
Hi AJ.
Your basically just protecting your long position etc.. long call insurance bear spread etc.. vice versa... How far out do you usually pick these option from your original strike price. (insurance)