Trade of the Day: Financial Select Sector ETF (XLF)

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The Murphy Oil Corp. (MUR) puts I recommended on Aug. 21 have topped my price expectations, and the stock traded within six cents of my downside target, so take your profits now if you haven’t already. If you got in close to my recommended entry, you should be sitting on a double-bagger by now. But I want to bring you a new bearish trade in the Financial Select Sector ETF (XLF), a put debit spread.

Using a spread order, buy to open the XLF Nov. 20th $23 put and sell to open the XLF Nov. 20th $21 put for a net debit of about $0.60.

Debit spreads may be a new strategy for some of you.

In simple terms, a debit spread is a cheaper way to buy an option. So, traders open a put debit spread on stocks and ETFs that they expect to go down, while traders open call debit spreads on equities they expect to go up.

A debit spread lowers the cost of buying options as the option that you sell to open (short) helps offset the cost of the option that you buy to open.

Since today’s recommendation is a put debit spread in the XLF, the trade is based on my expectation that the financial ETF will decline in the short-term.

Debit spreads do require the use of a margin account. But setting up a margin account usually only requires $2,000 in unallocated capital, depending on your broker (some more conservative brokers will require more, but that’s not typical).

Once you have that money designated and your broker’s approval, your broker will use that funding for your margin requirements for the debit spreads. So, essentially once you have your margin account in place, all of the debits for the debit spreads will come from that.

I had one of my Maximum Options subscribers ask me recently, “I understand that debit spreads are really just a way to trade puts and calls more cheaply. But I don’t have a margin account, and I’m still learning options, so I may not open one up for a while. Can I just buy the long leg of the debit spread?”

While some brokers will let you execute call and put debit spreads in a cash account, the short answer is yes, if you don’t have a margin account, you can just buy the long option in a debit spread. But often you’re going to pay twice as much, which is why debit spreads really are the way to go most of the time.

So, theoretically, if you did not want to execute the full debit spread in XLF and you just wanted to buy the long option, you could. But here’s why I don’t do usually do that myself:  When you lower your cost to enter a trade, you significantly increase your profitability and also decrease your potential loss.

Let’s look at how the numbers add up for this XLF debit spread.

My recommendation was to use a spread order to buy to open the XLF Nov. 20th $23 put and sell to open the XLF Nov. 20th $21 put for a net debit of about $0.60.

Don’t quibble over a few cents, either. If you can execute the trade for a debit of $0.62 or $0.63, that’s fine.

We were able to buy the long XLF Nov. 20th $23 put for about $1.04, and we sold to open the short XLF Nov. 20th $21 put for $0.44, so it made our net debit (or cost to open the trade) $0.60, or $60 per each contract we opened.

Now, the exact prices you get don’t matter so long as you end up with a 60-cent debit. You can buy the long leg for $1.20 and sell the short leg for $0.60. Or you can buy the long leg for $1.05 and sell the short leg for $0.45, etc.

Even though my broker requires that I use margin because of the short leg, the most I stand to lose in a debit spread is the amount of the debit multiplied by the number of contracts I trade. In the XLF trade, it’s $60 for every contract.

Now, if you had simply just bought the long puts, you would have paid $1.04, or $104 per contract, which is almost 75% more. And, thus, you stand to lose more.

Again, starting to use margin typically only requires $2,000 in unallocated capital, depending on your broker, and the money to fund a debit spread comes out of that $2,000.

Using the XLF trade and an example of 5 contracts, here’s how most brokers will calculate those margin requirements:

Buy to open 5 contracts of XLF Nov. 20th $23 puts at $1.04

$1.04 x 5 contracts x 100 = $520

Sell to open 5 contracts of XLF Nov. 20th $21 at $0.44

$0.44 x 5 x 100 = $220

$520 – $220 = $300 margin requirement for the trade, which is debited from your margin account. (Incidentally, it’s also the debit x the number of contracts: $0.60  x 5 x 100 = $300).

But, if you had simply bought five of the long puts, your cost would be much greater:

$1.04 x 5 contracts x 100 = $520

So, if you just bought the puts outright, you pay more and your potential loss is greater, which is why I prefer to use debit spreads to offset the cost of an options trade much of the time.

InvestorPlace advisor Ken Trester brings you Power Options Weekly, which delivers 5 new options trades and his latest trading advice to you each Friday. It’s the perfect ‘bridge’ between investing in ordinary stocks and the turbocharged world of options trading.

Trester has been trading options since the first exchanges opened in 1973 with a winning streak that goes back to 1984 with money-doubling average annual profits since 1990. Try Power Options Weekly today and receive 2 weeks for the price of 1 for only $19.95.


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