Options can be fun to learn, like solving a puzzle. They can also seem daunting, as if there's so many moving parts it would take forever to actually learn them all. But much like a proper golf grip, or keeping your elbow in while shooting a basketball, there are some fundamental principles that if properly understood make everything else come more naturally. I want to focus on two basic concepts that get way overcomplicated (or skipped entirely) in options education and prevent people from truly understanding the core simplicity of what's going on in a trade.
Debit vs. Credit, Buy vs Sell, Long vs. Short. Please.
This one trips so many people up. I can only blame my own industry on this for all of the ridiculous terminology that's been introduced, then used interchangeably over the years. Short puts, credit put spreads, debit call spreads, bull put spreads, credit iron condors, long butterflies, writing, over-writing. What???
No one talks about a stock from the perspective of the observer. We don't say a stock, trading $100, is a debit or a credit equity. We just say it's trading $100. You can either buy it for $100 or you can sell it at $100. If you bought it, you would now be long. If you then sold it, well, you would have just sold it. But if you sold it when you didn't own it, you shorted it. Pretty simple right?
Options are no different. If a call is trading $3.00 you can either buy it, or sell it. If you buy it, you want it to go up in value. If you short it, you want it to go to zero. Same as stock (The same is true if it was a put). Here's an easy way to think of buying or selling a call to open:
If you buy this call you want the grey to grow, if you short this call you want the grey to shrink.
The call is 3.00. It is something. It is an asset that is 3.00. Your net gains or losses are simply the distance from 3.00 in either direction when you go to close it, just like stock.
Debit vs Credit Spreads.
I think everyone gets how the value of a call works, but that is merely the set-up for part 2 on the list of things that are way easier to understand than most people think. Spreads. A defined risk spread is no different than the call example, but instead of one restrictive value (zero) it has two. Let use a 10 dollar wide call spread as an example. That call spread can be worth zero, ten, or anything in between. In this case it is trading 4.00. It can either be bought for 4.00, or sold at 4.00. And this is a very important point... whether you buy it or sell it, it doesn't change what it is. It is a ten dollar wide spread trading 4.00. The observer has no effect. Here it is visually:
Buying a call spread - If I were to buy that call spread for 4.00, I can lose up to 4.00, but I can make up to 6.00. Again, the 104 is the line in the sand in the stock. Anything above that on expiration and I make money if I am long, anything below, I lose money.
Shorting a call spread - If I were to short it at 4.00, I can make up to 4.00 but can lose up to 6.00. My risk/reward has simply flipped. If I am short it, and the stock is above $104 (at expiration), I lose money. Below $104, I make money. At or below $100 the spread is worth zero (yay!), at or above $110, it is worth 10 (boo, but at least it cannot be worth more than 10).
Again, it is a ten dollar wide spread that can be worth anything from zero to ten. Where you buy it or short it between those points determines what you are risking, and what you could make.
Let's put this into action. Using OptionsAI technology I can produce the same call spread for both a bullish and a bearish price target.
Bullish target, buying a call spread - In the bullish price target, I am buying the July 320/340 call spread, for 8.50. (buying the 320 call, selling the 340 call). Since it is 20 wide, it can be worth anything between zero, and 20. Because the target is bullish and I am buying this spread for 8.50, I need the stock to be above 328.50 (320 strike plus 8.50 paid) to make money. I can make up to 11.50 if the stock is above that, and the entire 11.50 if the stock is above $340 (the upper strike). Here's how it looks on the chart:
Bearish target, selling a call spread - Now, for a bearish target, I can short that same spread (which call I buy and sell reverses, now shorting the 320 call, buying the 340 call). Notice the green and red on the profit/loss zones simply flip. Again, it is the same trade (a 320/340 call spread), you are just now on the other side of it, shorting it and hoping it goes down in value:
In the case of shorting the call spread, I need the stock to finish below $328.50 (320 strike + 8.50 sale price) And it were to finish even lower, below $320 (on July 17th), I make the entire 8.50. The main difference now is my risk in this trade has flipped. If the stock finishes above $340, I lose 11.50. (note the Risk/Cost versus Gains at Target above). If I am short this spread at 8.50, I am risking the other 11.50 of the spread, to try to make 8.50.
Here it is again in relation to its possible values. Zero on the left, 20 on the right, and where it is within that space. If you buy the spread, you want the grey to grow, by the stock going higher. If shorting, you want the grey to shrink, by the stock going lower (or not moving at all). In this case the 0.00 is at $320 in AAPL, and the 20.00 is at $340. The spread is the difference between those two points. The arrow represents which side of the 8.50 you are on and therefore which direction you want the grey to go:
The key here is to free your mind from the clutter and focus on what matters. The basics of options get weighed down in confusing terminology. Thinking of options trades in terms you already understand is the first key to seeing the rest of the options matrix for what it really is. In this case, it's buying or shorting a spread and where within that spread, the price is. In the next educational installment we'll take it a bit further on credit and debit spreads and look at how and why to use them. For some more in depth examples of recent posts focusing on spreads:
- Using an in the money long call spread as a stock alternative in NVDA.
- Comparing long out of the money calls versus a long call spread for a similar cost in TSLA.
- And the use of short call spreads to "Fade a rally" in DIA
See a part of OptionsAI technology with your own price target and demo trades in AAPL HERE