Options  |  MAR 2003

Hidden Risks Of Debit Spread by Alex Mendoza

Hidden Risks Of Debit Spread by Alex Mendoza Understand all your risks when you trade. Strategies that seem harmless could end up costing you. Debit spreads are a favorite strategy among experienced options traders who understand the need to hedge risk, however strong their directional convictions. For example, if the price of the underlying instrument rises, instead of profiting from a simple call, you can hedge the risk of the total cost of the option by selling another call at a higher strike price. This would lower the cost basis of your trade. The tradeoff for the lower risk is that profits are limited to the difference between the strikes minus the initial debit. On the surface, common sense would lead you to believe that the risk in all debit spreads is limited to the debit of the trade. But the way assignment takes place in American-style, cash-settled options is such that any short option position, even within the confines of a spread, will give the holder of the trade unlimited risk — even a position as seemingly harmless as a bull call spread.

by Alex Mendoza