Option Spreads Can Offset Risk and Much More

Option spreads, like debit and credit verticals, can do more than offset monetary risk. If options traders only buy and sell options outright, they could be ignoring the benefits of using options to create more flexible positions and hedge risks. Options are so sophisticated that even adding another short position to a long position can lower a trader’s risk. As always with options, there are plenty of trade-offs too.

For example, say an option trader believes ABC stock will rally over the next month or so. The stock is currently trading at $39.50. He or she could buy the September 40 call for 3.50. What if ABC traded sideways or dropped in price over the next several weeks or the implied volatility of the option fell? The value or premium of the option would be lowered because of the positive delta and vega from the position.

Instead of just buying a call, a bull call spread could be implemented by selling a higher strike call against the long call with the same expiration. A September 45 call can be sold for 1.75, which not only lowers the cost and maximum risk on the trade to 1.75, it also lowers or totally negates the position’s exposure to implied volatility changes because the spread’s vega is lower than just the long call by itself. Vega measures the sensitivity of an option’s price to a change in implied volatility. The short call has negative vega, which can offset or negate the positive vega from the long call.

The same can be said of gamma. Gamma measures the rate of change of delta. A spread will have positive and negative gamma just like vega. Changes to delta will not be as severe since the gamma will be reduced more than a straight outright position. Of course, if the stock did move higher, an option trader would prefer positive gamma to increase the positive delta position.
Since everything in option trading is a trade-off, creating a spread lowers the risk but it also limits potential gains because of the short option. Unlike a long call whose maximum profit is unlimited, no matter how much the stock rises past the short strike, maximum profit is capped.

In addition, options traders should have a full understanding and be able to compare theta (option’s price change given a change in time decay) and delta (option’s price change given a change in the underlying) when buying calls and puts outright. Being aware of these “greeks” will help eliminate buying options with inflated premiums or choosing options with too little time left to expiration and other problems too.

Learning and understanding the trade-offs in options trading is critical for your potential success. The market has been very volatile as of late, which makes it even more critical to understand your current position. As I always say, take screenshots and study them later with the current option prices and option greeks. You will teach yourself more than you can imagine.

John Kmiecik, Market Taker Mentoring

Trader Education