Sunday, March 7, 2010

Options Trading Lesson - SPREAD TRADING

In options trading, there are some basic lessons that are the backbone of many other successful options trading strategies. How to engage in spread trading in options trading to enhance potential gains is one of these lessons.

Spread trading is a foundational tool that you should have in your options trading toolkit. It will allow you freedom and flexibility for enhanced profit and will give you defense against potential loss while reducing your overall risk. Now, let us look at this fundamental of options trading, the spread trade.

We have demonstrated how well options function in unison with a stock position. They enhance potential gains, provide profit protection and limit the risk of the entire investment. They enable us to manage risk in a single stock as well as an entire portfolio. But, as good as options are in conjunction with stocks, they can be even better when traded against each other.

Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.

Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option.

There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay.
There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.

Spreads are more advanced and sophisticated than the strategies discussed in our beginner product 'OPTIONS 101.' Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.

When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts - the option you buy and the option you sell.

Although the cost of most spreads is relatively inexpensive to initiate, they can provide a large percentage return and there is protection (limits) to both sides of the trade. Therefore, even experienced investors can profit from learning about spreads and their investment potential.

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Ron Ianieri
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at or 866-561-8227.

Wednesday, March 3, 2010

A Consistently Profitable and Low Risk Option Strategy

by Joelle Chan

Today, I'm going to talk about another options strategy... the CREDIT SPREAD. This is actually a directional strategy, which means you have to be either bullish or bearish about a stock.

Let's start with an example...
Suppose you are a big iPhone fan and are extremely bullish about Apple (AAPL). You looked at the chart and identified strong support at $148.28. You believe that there is no way AAPL is going to fall below $148.28. In that case, you can choose to sell the nearest OTM Put, which is the $145 Put. In order to protect yourself from any unexpected plunge in the stock, you buy an even lower OTM Put, which is the $140 Put.

Let's just suppose you sold the $145 Put for $2.70 and bought the $140 Put for $1.20. What you've done is you've just sold a Bull Put Spread.
Since the $145 Put that you sold is more expensive than the $140 Put, this spread is actually a credit spread; you earn premium upfront (($2.70 - $1.20)*100 = $150 per lot in this case).

If you are right and AAPL never trades below $145 for the entire period till expiry day, both the $145 and $140 Put options will expire worthless and you are a few hundred bucks richer.

However, if you are wrong (say Steve Jobs is suddenly ousted from AAPL again) and the stock price plunges to $100 on expiry date, your lose is limited. This is because although you will be forced to buy AAPL stock at $145 now, you can turn around and sell that same stock at $140, since you bought a $140 Put to protect yourself. Thus, your loss is only limited to $500 for every Put you sold.

But wait! Remember you earned a premium of $150 on that fateful day when you decided to sell the spread? This means your loss is actually $500 - $150 = $350 per lot (excluding commissions). That's not half as bad as if you had not bought the $140 Put. In which case you would have lost ($145 - $100)*100 per lot... Even after deducting the premium that you earned, you would still have lost $4500 - $270 = $4230 per lot...

That's the merit of doing a credit spread, as opposed to selling a naked option (i.e. selling an option without buying another to protect yourself)... Better safe than sorry.

About the Author
I've been trading options for 5 years and have been consistently profitable since I discovered the "secret" behind options trading. Find out more at my blog

Sunday, October 18, 2009

Time Spread: Options Seller Risk/Reward

The seller of a time spread buys the nearer month option and sells the outer-month option in a one to one ratio.

In order to profit from the sale of the time spread, the seller is looking basically for two things.
First is a decrease in implied volatility.
As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.

Second, the stock can move.
As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread.
So, as long as the stock moves in either direction away from the strike, the seller's position could be profitable provided that time decay does not outperform the stock movement.

Time, unfortunately, never works in favor of the time-spread seller.
The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.

Increases in implied volatility are also detrimental to the potential profits of the time-spread seller.
When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option's higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential.
For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility.
As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller's short, out month option will increase more in value than will the seller's long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short.
If volatility does not decrease or the stock does not move away from the strike significantly before the seller's long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration.
The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires and the seller is left short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem. While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they probably will not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at or 866-561-8227

Friday, October 16, 2009

Time Spread: Options Buyer Risk & Reward

Like most trades, time spreads have a maximum loss for the buyer.
As a buyer, you can only lose what you have spent.
If you paid $1.00 for the spread then your maximum potential loss is that $1.00.
If you bought the spread for $2.00, then $2.00 is the maximum potential loss.

The buyer of a time spread will be purchasing the out-month option while selling the nearer month option of the same strike in a one-to-one ratio.
Since the out-month option will have more time until expiration than the nearer month option, the out-month option will cost more. This means the buyer will be putting out money (debit spread) which makes sense. The buyer can only lose the amount of money they spent to purchase the spread. Thus the buyer's maximum risk is the cost of the spread.

The buyer can profit in several ways.
First and foremost, being a time spread, the buyer can profit by the passage of time. Options are wasting assets. So as the nearer month option decays away more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.

Second, implied volatility can increase.
As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher vega) than the nearer month option which the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.

Third, the buyer can make money due to stock price movement.
As stated before, a time spread's value is at its maximum when the stock price and the spreads strike price are identical (at-the-money).
You could have an increase in value if you owned an out-of-the-money or in-the-money time spread, and the stock moved either up or down toward your strike.
As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.

The buyer's risks are obviously the opposite of the rewards.
You can not stop or reverse time so the buyer of the spread can never be hurt by time.
Implied volatility, however, can decrease as easily as it can increase.
A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.

In the same way that stock movement in the right direction can be profitable for the buyer of a time spread, stock movement in the wrong direction can be costly.
As the stock moves away from the spread's strike, the spread decreases in value. That will create a loss for the buyer of the spread.

Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at or 866-561-8227

Options: How a Million Dollar Options Trader Sets His Stops: Underhanded Tips and Tricks

By: Jimmy Cox

When an options trader understand that it is important to set stops on all their positions, they often don`t know where to set them. As a options trader, how close should a stop be to price of the position they are entering? Should they be tight, set quite close to the price, or a little looser? What about trailing stops?

Here are some factors to consider that will help the options trader decide where to place your stops. Not every one of these applies to every trade, but the ones that do will give you some useful guidelines.

Perhaps the most important factor that affects stops is the question of how much you`re willing to lose on a single trade.
My rule of thumb is that the options trader should never lose more than 2 percent of your trading capital on any one trade.
Yet this can be tempered by other considerations, such as how much money you have in the position.
If you have a large amount of money in a position, 2 percent may be much more than you`re willing to lose. If so, the options trader should set stops accordingly.
However, if your account is small and you`re not well diversified, a 2 percent stop may be so tight that you stop out of the position almost immediately. If this is the case, the options trader should think seriously about whether you have enough money to trade.

Another matter to take into account is how risky you believe the trade to be.
If you think the trade is a sure winner and market conditions are favourable, the options trader may give the position more room to move.
But if you think it`s got only a fair chance of working out, or if the position has serious potential to drop, set a tight stop.

Also consider how volatile the position is.
If the position routinely moves up and down in a range of 15 percent or more over the course of the day, you can`t set tight stops. If you do, you`ll be taken out by the position`s normal volatility.
If the position is choppy and too risky to trade without tight stops, maybe you`d better look for a better position to trade.
If you have reason to be confident that the position will move upward even if it swings around a bit first, it doesn`t make sense to set a tight stop because you`ll just stop out as it swings. However, if you think it might possibly move up but will definitely drop if it slips below a certain price, then tight stops are a must.

There are also a couple of basic questions to ask yourself about the position to help the options trader decide where to place the stops.

First, is the position cheap?
When a position is inexpensive, even the smallest decimal price movement will be fairly large in percentage terms. This means tight stops may be knocked out more easily. It also means that if your broker has a rule that the options trader can`t set a stop closer than .25 below the current bid, you may not be able to set a tight stop until the price moves up.

And second, what is the time frame for the trade?
On a quick day trade, tight stops are a good idea.
On a position you expect to hold for a week or two for a trend play, tight stops may or may not be a good idea depending on other factors that you`re aware of. Market conditions should always be an important part of your decision.

If the market is trending sharply upwards, tight stops may not be necessary.
If you`re trying to go long in a bearish market, tight stops are absolutely necessary.
If the market is choppy, if it has no clear direction or if it`s full of nervousness and fear, use tight stops, and ask yourself whether you should be trading at all that day.

Which of these considerations is the most important?
Since no two trades are the same, different factors will dominate on different trades. Think about all of them on every trade. If you don`t, you`ll miss something important.
Setting stops is an art. You`ll have to experiment a bit and learn what works for you.
Occasionally the options trader may stop out of a trade too soon and feel frustrated, but remember this is just like paying for insurance. Sometimes you`ll be stopped out, but other times, you will save your capital. Over time, you`ll get better at setting stops. Eventually, you will be able to have a sense of each trade, and set the stops that work best for you. Then you will be a nimble and successful options trader who can trade with any market.

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