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Understanding Option Spreads

Jeff BishopJeff Bishop ·

Some refer to options trading as pure gambling, while others see it as a way to hedge an equity position and speculate on a trade through a risk-defined spread. You see, there are some who will tell you that buying option premium is a better strategy than selling option premium (and vice versa). When it comes to trading you should be open-minded, because there is a time for selling premium and a time to be a buyer of premium.

Generally speaking, you want to buy premium when implied volatility is relatively low. Conversely, you want to be a seller when implied volatility is relatively high. Now, many stock traders who are transitioning into options trading tend to place directional bets. However, if they’re unfamiliar on how options are priced, more specifically, the nuances of time to expiration, implied volatility and strike selection, trading them can be very costly and frustrating.

However, there are strategies out there that could mitigate some of these factors. By trading debit or credit spreads, you limit the role that time decay and volatility has on your position. With that said, it allows you to focus more on the directional aspect of the trade.


Long XYZ $100 call & Short XYZ $105

The above trade is an example of a debit call spread. By selling the $105 call against the long $100 call, the trader is able to reduce the cost of their position, as well as the role of implied volatility and time decay. The risk is limited to the amount at which the spread cost. On the other hand, the profit potential is capped off, in this example the trader sees a max profit if the stock goes to $105. However, if it trades higher they don’t benefit because their long $100 call is offset by the short $105 call.

Short XYZ $100 put & Long XYZ $95 put.

The above trade is an example of a debit call spread. By selling the $100 put against the long $95 put, the trader is able to define their risk and reduce the margin (compared to just shorting the $100 put naked).

Imagine being naked short calls on a biotech stock, and coming in the next day to see that their drug got FDA approval and the stock was trading 200% higher in the after-hours. If you only sold higher out of the money calls, you would have been hedged and your risk would have been defined. This is the beauty behind spreads. The downside, is your profit potential is capped off. However, it’s a trade off that makes sense in many cases.

Recently, a member of our community sent me a message about trading option spreads. They mentioned that they normally sold out of the money options, in attempt to take advantage of time value decay and high levels of implied volatility.

They were kind enough to allow us to use the trade to discuss as an example.

On 12/2/16 They put on a short SPY trade via a credit spread.

Now, if you recall, the last two months of the 2016, the market had an impressive move higher. Clearly this trade was a loser. However, the beauty behind spreads is that your risk is defined.

By selling the further out of the money, it acts as a built in stop. That is, the trader’s downside is clearly defined. This is even more important in individual stocks, where there is so much stuff that can happen overnight that hurt a position.

The trade went totally wrong in this example. However, it allowed for one very special thing to happen, the ability to live to fight another day. Shorting naked options, while being highly leveraged can be end up being a suicide mission if you trade the wrong stock and size inappropriately.

Here are some rules of thumb that I’ll leave you with:

If you’re trading near term options, implied volatility is less of a factor than longer term options. In addition, near term options experience time decay faster than longer term options, The wider the spread, the greater the profit potential and cost.

Also, be careful when you’re trading options during expiration, some brokers may close you out on a position early if they feel there is a chance you can get exercised. Often times, it’s at the least ideal point. With that said, trading option spreads are a great way to learn about options because they are not as risky and as expensive as buying outright premium, and less riskier than selling outright premium.

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