Option Traders Need to Consider Spreads

If you learned about options the way I did, you started with long calls and puts. I was fascinated that I could have a directional bias for the underlying and make money with options with considerably less risk than buying or selling shares. But as you progress as an option trader, you learn there may be different and better ways to do so than just buying a call or put. As always with options, there are trade-offs too.

Simple Example

For example, let’s say an option trader believes XYZ stock will rally over the next few weeks. The stock is currently trading at $59.50. He could buy the February 60 call for 3.50. But what if XYZ 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 probably be lowered resulting in a losing position.

An Alternative

Instead of just buying a call, a bull call spread (vertical debit spread) could be implemented by selling a higher strike call against the long call with the same expiration. A February 65 call could be sold for 1.75, which lowers the cost and maximum risk on the trade to 1.75. It also lowers the position’s exposure to implied volatility changes because the spread’s positive vega is lower than just the long call by itself. A long call has positive vega, so a decrease in IV would decrease the call’s premium. The short call has a negative vega position, which will offset all or some of the positive vega. Vega measures the sensitivity of an option’s price to a change in implied volatility.
This 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.

Option Greeks

In addition, options traders should have a full understanding and be able to compare vega (option’s price change given a change in volatility), 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 prevent buying options with inflated premiums or choosing options with too little time left to expiration and other problems as well.

In Conclusion

There are a lot of components that go into becoming a successful option trader. If buying calls and puts was the only answer to successful options trading, there would probably be more successful options traders out there.

John Kmiecik, Market Taker Mentoring

Trader Education