When to Consider a Spread

In a market like this, and for that matter any market, it is wise to consider a spread trade. Like everything in option trading, there are always trade-offs. The same is true of spreads. There are so many different risk/reward scenarios to ponder as well as positive and negative options greeks. With just a long or short call or put, you have either positive or negative delta, gamma, theta and vega. But when buying and selling, you have both for each greek. So, if an option trader wants to totally or partially offset some risk due to one or more of the greeks, a spread should be considered.

As an example, let’s say an option trader believes XYZ stock will rally over the next month or so. The stock is currently trading at $39.50. He could buy the December 40 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.

Instead of just buying a call, a bull call spread could be implemented by selling a higher strike call against the long call. A December 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 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 the greeks will help prevent buying options with inflated premiums or choosing options with too little time left to expiration and other problems too.

There are a lot of components that go into becoming a successful option trader. If buying call and puts were the answer to successful options trading, there would probably be more successful options traders out there. Many option traders use spreads, but you also need to fully understand what you are giving up and getting in return compared with single-legged option trades.

John Kmiecik, Market Taker Mentoring

Trader Education