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Introduction To Options Spreading

By Tony
Saliba

I intend to help
you, the reader, develop into a competent and successful options trader with the
aid of my daily column and a question and answer format that I will respond to
personally. I plan to initiate you into my own trading style, which I have honed
over many years of trading both “in the pits” and off the floor in an electronic
environment. I also indicated yesterday that a good motto, or battle-cry, for my
style of trading might be “Staying Spread is Staying Alive.” It is my opinion
that a huge percentage of private traders would be using the current market
prices to their advantage had they “spread off” their risk to a greater degree
over the past year.

In order to become
an adept spreader, you will need to begin to systematically build a solid
foundation of your knowledge base. Let us begin with the basics: what is a
spread and why should the competent options trader use them? A Spread is merely
a position consisting of two components transacted simultaneously or in close
succession where each position would profit from opposite directional
price moves in the market. Each part, or “leg,” is entered into simultaneously
in the hopes of either limiting risk or obtaining benefit from the change
in price relationship between them. There are quite a few different kinds of
spreads, and I will help you to understand some of the most important ones over
the next several months, including: Vertical Spreads (the Bull Spread and the
Bear Spread) and Volatility Spreads (including Straddles and Strangles, Back
Spreads, Time or “Calendar” Spreads, Ratio Vertical Spreads, and finally, the
highly effective Butterfly Spread).

Let’s step back for
a minute. There is no question that an options trader can get the most bang for
his buck by being long or short the right put or call at the right time. For
example, if you are long an in-the-money call and the stock takes off, your
potential profit is theoretically unlimited! Now this approach is fine under
certain conditions: if you have sufficient information about market activity and
volatility; time enough to follow the markets closely all day long; and lots of
money to risk if you’re wrong! However, I strongly contend that with a multi-leg
position, a bright strategist will do better in more markets over the long haul.
Trading in the options markets can be fast and furious, and when the smoke
clears, it is always the disciplined, methodical trader who will end up
profitable in more cases then not. This is perhaps the fundamental theme that
will run through all my lessons, so mark it down now!

Before we dive in
and outline various specific spreading strategies, we need to define some terms
so we can locate ourselves in the spreading universe. First let’s distinguish
Directional Spreads from Volatility Spreads. Once we
understand the concepts behind these terms, we are on our way toward developing
a powerful spreading armamentarium.

I. Directional
Spreads

A trader would put
on a Directional Spread when he is focusing on the underlying
directional price movement (up or down). For this trader, the volatility in
the market is of secondary importance, he rather wants to harness the bullish or
bearish movement he foresees happening. If he goes into the position with a
bullish sentiment, he wants his spread to remain bullish i.e. delta positive,
regardless of any change whatsoever in market conditions. Conversely, if
bearish, the trader wants his spread to remain bearish, or delta negative, “come
hell or high water,” e.g. if volatility, or interest rates, shift.

The first type of
Directional Spread that we’ll cover will be the 1:1 Vertical Spread. This
simple combination gives you a range of profitability with less risk than the
outright purchase of a naked put or call. The trader has put on a Vertical
Spread when he has both purchased one option and sold another where both options
are of the same type (call or put) and expiration
(e.g. July) but have different strike prices. (In a future lesson
we will see that sometimes options traders use the term Vertical Spread to
describe a delta neutral spread with multiple options where more
options are bought than sold, but this is getting ahead of the game for now.)

Let’s begin with
some more basic definitions: Bull Spreads and Bear Spreads. A Bull Spread
is a strategy involving two or more options that will result in a profit from a
rise in price of the underlying. A Bull Spread would be implemented by an
investor who was bullish on the underlying but who is not bullish enough to buy
a call option straight out.

Conversely, a
Bear Spread is a strategy involving two or more options that will profit
from a decrease in the price of the underlying. This investor is bearish about
the underlying. He hopes to capitalize on what he foresees as a downward move,
but is somewhat more risk averse than the outright buyer of a put.

A good rule of thumb
for determining the “bias,” or bullishness or bearishness of a spread is this:
whether you buy the lower strike option or the higher strike option
determines whether your spread is bullish or bearish. A bearish strategist
would go long the higher strike, whereas a bullish investor would go long the
lower strike. The rationale behind this statement will be made clear in the
examples below.

Both Bull Spreads
and Bear Spreads come in two “flavors,” if you will. Bull Spreads can be either
Call Bull Spreads or Put Bull Spreads, and Bear
Spreads can be either Call Bear Spreads or Put Bear Spreads.
The distinctions begin to get complicated so get out the pencil and write this
stuff down!

A Call Bull
Spread consists of the purchase of one call option with a lower strike price
and the sale of a another call option with a higher strike price.

A Put Bull Spread
consists of the sale of one put option with a higher strike price and the
purchase of another put option with a lower strike price.

A Call Bear
Spread consists of the sale of one call option with a lower strike price and
the purchase of another call option with a higher strike price.

A Put Bear Spread
consists of the purchase of one put option with a higher strike price and the
sale of another put option with a lower strike price.

II.
Volatility Spreads

A Volatility
Spread is a slightly more complicated beast, so please pay attention and try
to follow me. The trader who puts on a volatility spread is chiefly
interested in the degree of volatility of the underlying, and only secondarily
in the directional movement of the underlying (Volatility, for our purposes,
can be defined as the measurement of price fluctuation of the underlying, i.e.
the “up and down-ness” of the underlying as it deviates from its average annual
price). Now the Volatility Spreader may have a bullish or bearish
perspective on the market, but unlike the Directional Spreader, if he doesn’t
factor in volatility, the intended direction of the spread could be reversed.

We will cover
Volatility Spreads in depth in a later lesson, so I just want to stress a couple
of their characteristics for now. First, volatility spreads are delta
neutral, (see the glossary at
www.itichicago.com/glossary.htm
for this and other options terminology), that is, the total deltas of the
long position equal the total number of deltas of the short position, i.e. long
and short deltas cancel each other out. Second, volatility spreads are
sensitive to a number of factors, including the price of the underlying, time
until expiration, volatility, and finally, interest rates and dividends.