3 Advantages of Spread Trading

by Tyler Craig | May 25, 2011 9:39 am

3 Advantages of Spread Trading

It seems buying a call or put option is the play of choice for most novice options trading[1] investors. The allure of these simple directional bets is certainly understandable. They are drastically cheaper than buying stock, offer the potential for much higher percentage returns, and provide a limited risk/unlimited reward payoff. Unfortunately most traders learn the hard way that buying options is not all sunshine and lollipops.

For starters they are very unforgiving. If the stock moves in an adverse direction or simply takes too long to stage a sufficient favorable move, or if implied volatility drifts lower, long option trades will swiftly deliver you to the house of pain. Your success with buying options hinges to a large degree on your ability to accurately forecast the future price direction of a stock. Rather than leaving such a feat to chance, keep a track record of your trades over the next few months to assess your ability to forecast direction. If you do indeed have a knack for using charting or some other timing tool to make consistent profitable directional bets, then call and put options may deserve to have a permanent place in your bag of tricks. But, if you find your stock picking and directional betting would likely be bested by a dart throwing monkey then perhaps you’d benefit from utilizing option spread trades.

Find more option analysis and trading ideas at Options Trading Strategies[2].

By definition a spread is a strategy that involves buying one option while selling another simultaneously. With that broad of a definition there are quite a variety of option strategies falling under the spread banner. Consider the following three advantages of entering a bull call spread[3] over buying a call option outright.

Less Risk

The maximum risk for most strategies where traders pay money to initiate the trade is limited to the debit paid. Because a spread involves both buying and selling options the premium received from the short option partially offsets the overall cost of the trade. By reducing the debit, the risk is also diminished. Suppose two traders decide to initiate bullish trades on a $50 stock. The first trader, Aggressive Al, decides to swing for the fence by buying a 50 call option for $5. This $5 also represents his maximum risk. The second trader, Steady Eddie, decides to take the more conservative route by entering a call spread by purchasing a 50 call option for $5 and selling a 55 call option for $2.50. His overall cost and risk comes out to $2.50. By entering a call spread Steady Eddie has successfully cut the overall risk of the trade in half.

Lower Theta Risk

How about both positions’ sensitivity to time decay? Remember when traders purchase an option they acquire a negative Theta[4] position which will lose value as time passes. When selling options, traders are on the flip side of the coin and actually profit as time passes. Suppose the 50 call option has a theta of -10 and the 55 call option has a theta of -5. By simply purchasing the 50 call option Aggressive Al has acquired a position which theoretically loses $10 each day. Eddie not only purchased the 50 call but also shorted the 55 call. He theoretically loses $10 a day on the long option, but makes $5 a day from the short option. Thus, Eddie’s overall position loses a total of $5 a day. Because Eddie entered a spread trade his exposure to time decay is half as much as Al’s.

Lower Volatility Risk

Volatility is another variable that can be minimized somewhat when entering a spread trade.  Option values increase as implied volatility[5] rises while decreasing as implied volatility falls. The Greek Vega is used to measure an option’s sensitivity to changes in implied volatility. Suppose the 50 call option possesses a vega of 20 and the 55 call option has a vega of 12. Since Aggressive Al purchased the 50 call option his position gains (loses) $20 for every one point increase (decrease) in implied volatility. By entering the spread, Eddie’s position is noticeably less sensitive to changes in implied volatility. The combination of the long 50 call and short 55 call yields a position vega of 8 which means his option trade gains (loses) $8 for every one point increase (decrease) in implied volatility.

In sum, the spread trade effectively cut down the dollars at risk as well as the position’s exposure to time decay and implied volatility.

Follow Tyler Craig on Twitter@TylersTrading[6].

Endnotes:
  1. options trading: http://investorplace.com/options-trading/
  2. Options Trading Strategies: http://investorplace.com/category/options-trading/trading-strategies/
  3. bull call spread: http://investorplace.com/6097/vertical-options-spreads-bull-call-spreads/
  4. Theta: http://investorplace.com/40891/greeks-predict-prices-at-options-expiration/
  5. implied volatility: http://investorplace.com/308/understanding-how-implied-volatility-affects-options-traders/
  6. Twitter@TylersTrading: http://twitter.com/tylerstrading

Source URL: http://investorplace.com/2011/05/3-advantages-spread-trading/
Short URL: http://invstplc.com/1nukkFB