Which Option Strategy is Best For Trending Markets?
A lot of money can be made by simply riding a trend. Not only is going with the trend wise, but 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? Simply holding calls (in an uptrend) or puts (in a downtrend)?
You might be surprised to learn that greater returns at less risk can be had using combinational strategies such as a vertical debit spreads, horizontal debit spreads, back spreads, and synthetics. These strategies use two or more different options on the same underlying to create unique risk/reward profiles that single option positions cannot provide.
SPREADS
Spreads are slower acting than single option positions. Thus you don’t have to watch them as closely. And a single counter-trend day won’t be as likely to scare you into exiting your position prematurely.
I wrote about vertical debit spreads in a prior article. Briefly, a vertical spread is constructed by buying one option and selling another option of the same type (call or put) in the same expiration month. (Such a spread is said to be a “vertical” spread because the options differ only by strike, and in an array of options you picture the strikes running vertically.) When the option bought is more expensive than the option sold, the spread is said to be a “debit” spread because its opening results in a net debit to your trading account.
A horizontal spread is constructed by 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.)
Consider the ever-popular OEX. With a moderately bullish target (represented by the cross-hatched area), clearly the best vertical debit spread (brown line) and the best horizontal debit spread (tent-shaped line) beat the best simple call purchase (purple line) within the target area. All three strategies can potentially lose 100% of the investment if your forecast is wrong and the OEX declines. (However, notice that the horizontal debit spread won’t lose 100% until the OEX drops pretty far.)
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 remember, a simple call purchase is a fast moving position, requiring careful attention, discipline, and, sometimes, nerves of steel. And you should ask yourself if that is what you really want.
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 back spreads and synthetics. I’ll be covering those in the next two articles.