The Spread Advantage

Near 11k and no signs of stopping. Undoubtedly markets are treating all the bulls very well. But as the famous quote goes “Everything that goes up; must come down”. With budget around the corner, the threat of this quote coming true is looming large on all of us. With lot of positives already factored in and markets pushing higher any crack down can be severe. Does this mean we change our stance, no, we just change our modus operandi. From vanilla positions we can move to spreads now.

Option spreading is an unique advantage of the option markets. Option spreads enable you to create strategies where you limit your risks and maximize your gains. Spreads allow you to adjust your positions as the market changes to neutralize market risks. Credit spreads, debit spreads, strips, straps etc are all types of option spreads.

A well designed spread is one with an excellent risk-reward picture. For the option buyer, spreads are, to use cricket jargon, for those who are satisfied with singles and doubles instead of boundaries. For the option writer, spreads can remove the unlimited risk present with naked writing. The big advantage of spreads is that spreads can be designed with a high probability of profit and very limited risk.

A spread is best defined as a combination of buying and selling (writing) two or more different options at the same time, on the same underlying. Any professional option trader should know how to spread and use it as a tool and as part of his option trading arsenal. The difficult part of spreading is learning how to design a spread and understand the risk-reward picture for the spread, which takes some practice.

One of my major rules of successful option trading is to minimize your trading. There are high costs to option trading. Not only are there commissions, but also there is slippage—the distance between the bid and asked price. And that slippage can be quite large, sometimes a large percentage of the option price. That is a real cost.

Hence, when you trade spreads, you magnify that cost. Just a simple spread will usually involve four trades—two trades to get in and two trades to get out. Add to this the complexity and difficulty of getting in and out of spreads, and you can see the challenge you face. Such obstacles mean only one thing when you are spreading: keep it simple!

How to Design a Stock or Index Debit Spread?

• Buy a close-to-the-money option.
• Sell a further out-of-the-money option.
• The maximum profit must be at least 100%.
• Do not sell an option very cheap.
• Try to design a spread with a probability of profit of 35% or better.

Happy Trading.

Cheers!!!