How to Trade in Trending Markets

A lot of money can be made by simply riding a trend. Not only is going with the trend wise, buying and holding a position for weeks is less stressful than day trading.

What would you think is the best options strategy to use in a trending market? Most traders would probably guess that holding long calls in an uptrend, or long puts in a downtrend, would result in best possible return.

Actually, the combinational strategies such as a vertical debit spreads, horizontal debit spreads, back spreads, and synthetics can provide greater returns with less risk. All these strategies use two or more options on the same underlying to create unique risk/reward profiles that long option positions simply cannot provide.

Spreads

A spread is said to be a "debit" spread if the option bought is more expensive than the option sold. Opening a debit spread results in a net debit to your trading account. A "credit" is when the option sold is more expensive than the option you bought. Opening a credit spread results in a credit to your trading account, but you are required to hold margin against the trade for as long as it is open.

I have written about both vertical debit and credit spreads. A vertical spread is made by buying one option and selling another option of the same type (call or put) in the same expiration month. It is said to be a "vertical" spread because the options differ only by the strike price, and in an array of options you picture the strikes running vertically.

I have also written about horizontal spreads, which involve buying one option and selling another option of the same type (call or put) in the same strike but different expiration months. Such a spread is said to be a "horizontal" because the options differ only by month, and in an array of options you picture the strikes running horizontally. I have primarily covered only horizontal debit spreads, since I have never see a case where a horizontal credit spread would be the best trade. You can also modify this strategy by selecting different strike prices for the long and short options. That creates a diagonal debit spread, and that trade can have some very interesting properties as well.

Consider a moderately bullish target (represented by the cross-hatched area in the figure below) on the popular SPY equity options, which track the S&P 500 index.

Spy Analysis Chart

OptionVue5's TradeFinder was able to find a number of possible vertical credit spreads (purplish backwards "Z" line), vertical debit spreads (nearly exactly the same risk profile of the vertical credit spread) and horizontal debit spreads (the green tent shaped line) that would perform better than the best possible long call option position (blue line) within the target area.

Spreads are slower acting than single option positions, so you don't have to watch them as closely as long option positions. One important thing to understand about spreads is that they do not realize their full potential until expiration day of the short leg. So if the market makes its anticipated move quickly, some patience will be required as you wait for the spread to mature. If this happens, it may make you wish you had simply bought calls. But on the positive side, a single counter-trend day won't be as likely to scare you into exiting your position prematurely.

Usually, vertical and horizontal debit spreads are the best strategies for trending markets. If your forecast is for a moderate move over the next several weeks, these strategies pay better and are less volatile than simple option purchases. Two other strategies for trending markets – although with unique characteristics, are backspreads and synthetics.

Len Yates is the President and founder of OptionVue Systems International and has earned worldwide recognition for his groundbreaking work in options analysis software. He has published numerous books and articles on options analysis and trading strategies, and is a primary contributor for the educational site DiscoverOptions.com.