Spreads Can Be an Option Trader's Best Friend

Can you imagine if option traders only bought and sold options outright? Trust me, there are some who do out there, and I have talked to them. If this is you, don’t worry because there may be a better way to trade options. Without trading spreads, option traders are really ignoring the benefits of using options to create more flexible positions and hedge risks. Options are so multi-faceted that even adding another short position to a long position can lower a trader’s risk. As always with options, there are trade-offs too.

Take a look at the example below. An option trader believes XYZ stock will rally over the next couple of weeks or so. The stock is currently trading at around $110. He could buy the September 110 call for 3.10. 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 most likely due to time decay.

Instead of just buying a call, a bull call spread could be implemented by selling a higher strike call against the long call like below. A September 115 call can be sold for 1.27, which not only lowers the cost and maximum risk on the trade to 1.83 (3.10 – 1.27), it also lowers 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.

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.

Also, 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 eliminate buying options with inflated premiums or choosing options with too little time left to expiration as well as other problems.

A lot of components go into becoming a successful option trader. If you have heard me talk, you know how I feel about management. But if buying calls and puts were the answer to successful options trading, there would probably be more successful options traders out there. In my opinion, spreads need to always be in the conversation about what strategy to apply.

John Kmiecik, Market Taker Mentoring

Trader Education