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How to Spread Trade Options Based on Bias
12/03/2009 12:01 am EST
In my most recent class in Dubai, United Arab Emirates, I was going over the two types of option trading: (1) Directional option trading using long calls or puts, and (2) Volatility trading using spreads of various kinds. As usual, my personal bias was towards the latter one, which involves option premium selling as well as simultaneous option premium buying. The concept of short selling was somewhat foreign to most emirates, the citizens of the UAE.
Hence, I first needed to explain how basic shorting works: Sell high and buy back low. On their three local stock market exchanges (NASDAQ Dubai, Abu Dhabi Securities Exchange, and Dubai Financial Market), shorting is prohibited. According to Sharia, Islamic religious law, trading in debt is simply not allowed. Moreover, none of those exchanges traded options; hence, most of my option teaching was spent using our American exchanges and our American products.
Vertical Credit Spread
It was on one of our American optionable stocks that I was placing a vertical credit spread involving the puts as the driver. This type of spread is also known as a bull put spread, and we have discussed it on different occasions before. I highly suggest for any readers unfamiliar with the concept of simultaneous buying and selling of option premium to browse our prior articles as a reference guide for understanding the fundamentals of a bull put spread.
Essentially, we were looking at a product that was currently trading for $48.98 and we had observed that there was no fundamental data on the product that was of significant importance on the horizon; no stock splits, no near earnings releases, and no dividends to be paid out in the near future. Next, we looked at the technicals and observed a strong area of support at the $47 zone.
We also checked the implied volatility on the product, which was currently in the higher range. Having these three things (fundamental, technical, and implied volatility) checked, we proceeded with the selection of an option strategy that would match our slight bullish bias. One of the teachings of Online Trading Academy option instructors is to sell premium when the implied volatility is high; therefore, the strategy that I had selected was a vertical put credit spread.
As I was going over the trade, a lot of questions were asked regarding the net premium credit received, and some of the students wanted to receive even greater premium from what the June 47/46 bull put would give us. Figure 1 below presents several other scenarios involving the different strike prices. Observe that I have named this figure "Single Width" for a good reason.
The main reason for calling it a single width is that the spread of the strike prices is only a single point wide. The four choices described above involve selling the June 47 put and simultaneously buying the June 46 put, resulting in a credit of only 30 cents, which in the second row is labeled as Max P, meaning the maximum profit. Due to the fact that the spread was only one point, the maximum loss, or MAX L, in the chart above, is only 70 cents.
The way to calculate the maximum loss is simple: The spread of the width between the two strike prices minus the premium received. In the case of the 47/46 put, that would be 47 put minus 46 put equals a dollar. Then, 30 cents of our maximum profit gets subtracted from $1.00, giving us the maximum possible loss.
The fourth row on the chart, ROI, stands for the return on investment. The calculation involves the division of maximum profit by maximum loss. The fifth row is what I call "Protection," also known as cushion. It looks at the current price and then subtracts from it the sold strike price. The difference is the amount by which the stock price could move against the trader before he or she must take an action. The very last row takes into consideration only the protection row, and based on it, labels the different spreads as conservative, moderate, or aggressive.
For instance, my initial spread of 47/46 had room of over two points to go against me; therefore, I labeled it as a conservative. The second spread, 48/47, has decreased the amount of protection that I have given to myself to slightly over a point, so I called it a moderate. The third spread, 49/48, gives us only the cushion that equals the amount of the premium received, which I personally would not even consider placing at all, so I named it aggressive.
The last and most aggressive example is the spread 50/49, which involves selling the put strike price at 50 while our product is trading at 49. In such case, the trader is testing his or her luck because the product must move above 50 and stay above 50 in order for the bull put to be profitable. At first, this might seem like a crazy trade, but as we all know, a $49 product could move more than just few cents in the remaining three weeks or so.
I personally prefer to place the trade in such a way that the product does not have to do much of anything. Placing the June 50/49 put certainly isn't my first choice of a bull put. Lastly, the columns in Figure 1 visually present the statistics that show as the exposure increases, the amount of the credit received also increases. Observe that the super aggressive bull put spread (50/49) actually gives us the greatest premium as well as the greatest risk out of the four choices presented.
NEXT: When to Use a Two-Point Spread |pagebreak|
Next, the question was raised as to when a two-point width would make more sense over the single-width spread. The simple answer is when the directional bias is very strong. For instance, if a trader is completely bullish on the optionable product that he or she is trading, then selling a naked put would be the best possible strategy. However, selling a put and simultaneously buying another put is done strictly as a way not to be left uncovered, or naked.
Basically, the buying of that second put could be viewed as insurance so the broker requirements could be met. Every time a trader buys premium after selling higher-cost option premium, the net credit is decreased. A two-point width between the strike prices increases the size of net premium, and three points would increase it even more. Yet, as always with options, when something increases, something else at the other side gets affected as well.
In the case of a two-point width spread, the maintenance fee for two points is double of what it was for the single. If we went with a three-point spread, then the maintenance would be three times greater. Figure 2 below illustrates that point both mathematically and visually.
Figure 2 above shows two examples that still involve selling of the June 47 put, yet the bought strike prices are much further away from the sold one. Two points between the strike prices means that the maintenance held by the broker (1.46 per contract) would increase as well, as it is in the case of the 47/45 spread. At the 47/44 spread, the amount held by the broker is even greater (2.26 per contract).
Rate of Return
In a nutshell, one of the best ways to look at options is by looking at the rate of return, and the one-point width (47/46) spread gave us 42% of ROI, the two-point width (47/45) gave us 36%, whereas the three-point (47/44) spread gave us 32% of return on our investment. It is according to this measurement that I have labeled the terms conservative, more conservative, and the most conservative.
An additional way of looking at spread selection is by focusing on our market outlook. Figure 3 presents the facts in such a way that the naked put gives the greatest return, but at the same time, the greatest risk due to the open bullish bias. The moderately bullish bias reduces the exposure and at the same time gives a somewhat decent return. The slight bullish bias involves a single-point width spread between the strike prices and gives us a small return with decent protection.
In conclusion, in this article, I have argued that naked put selling when the volatility is at extreme levels would provide the seller with a "juicy" premium. At the same time, the exposure would be technically unlimited (though the price could only go down to zero), while the reward would be limited to the premium received. Nonetheless, the safer way of trading would be by using spread trading, or the simultaneous selling and buying of option premium.
The buying of "insurance" a few strike prices away from the sold strike price would take away some of the exposure, yet the wider the width between the strike prices, the greater the level of directional bias. Once again, which strike price to sell is of the utmost importance, yet make no mistake about the fact that protection/insurance should be placed on any given trade. Which width of the strike price to select is based on our directional bias.
By Josip Causic of OnlineTradingAcademy.com
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