Robinhood is everyone’s favorite trading platform. However, based on their trade execution, there’s a dangerous way an emerging investor can end up owing a lot of money quickly, even if they get the trade right. I’ll go through today a quick example of a debit spread and how to do it correctly on Robinhood.
What is a debit call spread?
Before we start, let’s get accustomed to some of the jargon. Credit is an increase in your account or spending (e.g., a credit card gives you more money to spend than you may currently have). Debit is an outflow or expense (each time you use your debit card, your money leaves the account). So a debit spread means it’s a strategy that will require outflow or investment of money initially.
Options can be in 3 states: at-the-money, out-of-the-money, in-the-money.
- At-the-money or ATM means the strike price of the option is the same as the stock.
- Out-of-the-money or OTM means the strike price of the option is different from the stock so that if the option expires today, it is worthless.
- In-the-money or ITM means the strike price of the option is different from the stock so that if the option expires today, it generates a profit.
Lastly, a call option is an option that gives the buyer the right to buy a stock for a price set by the strike from the seller.
Setting up a debit call spread
A debit call spread is an options strategy to make money when we think a stock price will go up but also want some protection in case we get it wrong. I will give an example below of a straightforward way to set up a debit call spread.
- Buy a call option ATM (at the money) at a specific expiration.
- Sell a call option OTM (out of the money) at the same expiration date as the purchased call.
ATM premiums are always higher or more expensive than OTM since there’s a larger chance for the ATM options to pay out. So in our case, the cost of the premiums to buy a call option will be more than the premiums gained from selling the same duration call option in this spread. The difference results in a net expense or a debit, and it’s why this strategy is called a debit spread.
To understand how the debit call spread pays out and the protection we gain, we need to know how to read a payout chart.
Option bros provide a more in-depth write up of debit spread here.
The X-axis of this chart is the stock price starting from $0 with the Y-axis representing the potential profit or loss to us as an investor. The green arrow represents the payout of the debit spread in response to the stock price.
Long call strike price = our strike price of the ATM option we bought.
Short call strike price = our strike price of the OTM option we sold. We can see that the strike price is higher than the ATM strike since it’s a call option.
We can see that even if the company goes bankrupt and the stock price drops to 0 the next day, our losses are limited by this strategy (max loss line). However, to buy this insurance, we traded some of our upside — even if the stock triples in value, our gains are capped (max profit line).
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The strategy starts paying off when the stock price increases by more than the difference between our options or our debit for this strategy. E.g., we bought an ATM call option for $110, which breaks down to $1.10 per share, and we sold an OTM call option for $90, which equates to $0.90 per share. Our net debit is $0.20 per share, and the moment the stock increases by $0.20 per share, our debit spread is passed the break-even point.
The dangers of Robinhood
There’s a good chance we can lose money on Robinhood even if the options strategy expires on the far right of our payout graph.
So a good friend of mine bought a 400–410 call debit spread on Tesla 2 weeks ago. On the Friday it expired, it was in the money by $9. (Tesla was at $419). Robinhood closed it and bought him the shares at $400. Then, instead of selling them for $410 and giving him his $1000 credit (which is the way most of us understand a credit spread to work), Robinhood waited until Monday to sell the shares at $360 thus putting him $40k in the hole on his account. When he finally got ahold of them 2 days later, they said his account was right and since he did not close the spread before it expired, there was not a buyer Friday (non liquid) so they could not get rid of his shares until Monday after Tesla crashed. They automatically sold all his other stocks without his consent to help cover his losses and now they are in a lawsuit? I Guess the moral of this story is never let a debit spread go to expire on Robinhood. Sell it before it expires. — anonymous
What happened was a classic case of Sunday Scaries for the stock market. Our financial markets are heavily influenced today by trading algorithms that move hundreds of millions of dollars at proprietary signals not known to the rest of us. At any moment, the algo’s can decide to slam the sell button, and we have to ride out the volatility. In my private investing slack channel, we often discuss the risks of holding short-term options through the weekend and offloading or maturity roll-up strategies.
The problem at hand isn’t the algo’s but rather how Robinhood treats the assignment of options. The assignment is the obligation for both sides to honor the agreement of the option contract. That means if the call option expires ITM, the seller is assigned to sell the shares to the buyer of the call option at the strike price. In the case of Robinhood, they have their own rules on how expiring options are treated.
Anonymous’s friend (let’s call him Chadwick) had one leg that was ITM and another leg that was OTM. The profit was $9 per share ($419 stock price−$400 call strike −$10 debit = $9). Let’s break down what happened and how he ended up losing money.
- At expiration, Chadwick was assigned the call option he sold. He owed TSLA shares for $410 per share to the buyer of the call. Likely, he didn’t have shares of TSLA to satisfy the contract, so he needed to buy shares for $419 on the market and then sell them for $410. That results in an outflow of $419 per share and inflow of $410 per share (- $419 + $410 = $-9). Note: options contracts are in denominations of 100. So at a minimum, the outflow was -$900 for a single option contract.
- Chadwick was then assigned the call options he bought with a strike price of $400 per share. ( $-9 − $400 = -$409) or -$40,900 per contract.
- The negative balance would be ok because Chadwick could have sold the shares he just purchased at $400 per share for $419 per share or $41,900 per contract on the open market for a profit of $1000 per contract.
However, the sequence that Robinhood executed the legs of the options resulted in step #3 skipped because markets were closed, and his account had a temporary written loss of -$40,900 per contract. His loss triggered an automatic sell on Monday morning to recover the balance. TSLA opened at $360, locking in a huge loss (-$409 + $360 = -$49) of $4,900 per contract. We could probably guess at this point that Chadwick traded 9–10 contracts of what seemed like a debit spread with a theoretical maximum loss much lower than $40K.
Always be informed
It’s arguable if Robinhood is completely at fault; however, their response to Chadwick about not “closing out a spread” is inadequate. For the time being, if you find yourself in a debit call spread, always sell to close both legs a few hours right before market close to avoid an unrecoverable loss. Smash that sell to close button!
Unfortunately, as an emerging investor who didn’t fully understand how things worked, Chadwick is the one holding the bag and will most likely be tied up for a long time in a legal battle. He did not only lose his hard-earned savings but is also losing out on investing as the economy recovers from Covid-19.
Savvy investors often use options to hedge their risk instead of YOLOing with levered positions. Some of these hedging strategies are very effective but require a solid understanding of derivatives and options to pull off correctly.