Stock Option Trading Strategies - Debit Spread

One of my favorite stock option trading strategies is the Debit Spread. This is when you buy a Call option on a stock and then sell a Call option (at a higher strike price) on the same stock.

I like to use this strategy whenever I have bought a Call option and have considerable profit. It allows me to take my money out of the investment but still generate extra profit for free!

Here is a real example of how I make free money using a Debit Spread (as of 7/11/08):

On April 4, 2008 I bought a Call option (CLFJJ) on CLF. The contract cost me 20.30 for a total of $2,030.00 per contract. Two weeks later on April 14, 2008 the contract had risen to a value of 27.35 for a gain of 34.7% in only two weeks.

At this time most investors will either hold or sell. I felt the market wasn't too stable, and since I'm not a greedy person a 34.7% gain in two weeks was good for me.

Now here is where a Debit Spread can be advantageous. I could take my money out and still keep my contract and make more money. The first thing you need to do is look for a Call option that is at a higher strike price than the one you already have. For example CLFJJ has a strike price of 100.00.

So I started looking for a Call option I could sell that would net me about $20.00 (the price I paid for CLFJJ). Now remember, this new Call option must also have a higher strike price than the original one. The option I found was CGJJM. This option had a 130 strike price, definitely higher than CLFJJ's strike price of 100. I could also sell it for $19.95 and get most of my money from CLFJJ back.

After this trade my results were this: I paid $2,030 for CLFJJ. After two weeks I got back $1,9995 by selling CGJJM for $1,995. My total investment now after two weeks is only $35 per contract! Basically what I am doing is just leaving in $35.00 of my principal and the $705.00 of profit I made the past two weeks.

Now I have my money back in my pocket to buy more options. The $35 principal + $705 profit, is left to grow some more.

So how has it fared today (July 11, 2008)?

CLFJJ is at 59.60 (+$5,960) while CGJJM is at $47.90 (-$4,790) for a difference of $1,170.00. I've made an extra $430.00 in profit. Remember, I left in $35 principal + $705 previous profit. I've made another 58% gain in the last three months.

Even if CLF went down instead of up over the same time period you would have made extra money because you bought and sold a Call on the same stock. Whichever way CLF moves, one option goes down and one option goes up. Again, your principle is out and your $35 + $705 profit is protected by the Debit Spread.

About The Author

W Henry Boyett retired from his job three years ago and now trade stocks and options for a living. He shares his picks and knowledge with others so that they too can retire sooner, by trading stocks and options.

If you would like to get his latest stock picks and tips, visit bombay stock exchange to bombay stock exchange.

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