Why Trading Option Spreads Is a Smart Move

10/19/2010 12:01 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Option traders spread to optimize their risk:reward. Being long one option and short another option creates a symbiotic relationship between the components of the spread. One hedges the risk of the other while proportionately allowing for a high potential profit. Any experienced option trader knows trading a spread is usually better than trading an outright option.

The Big Picture

With each individual option trade, a spread helps avoid having all the risk concentrated in one risk center. But consider the big picture: When traders have an inventory of option spreads that are all the same—such as all long option plays, or all income trades—their portfolio risk becomes concentrated all in one risk center overall.
What's the solution? Traders should consider their entire options portfolio to be one big spread—a spread of spreads.

A Spread of Spreads

Consider a macro view of trading—a manager’s perspective—if you will. Each individual spread can be thought of as a single unit with characteristics that have market exposure to direction, time, and volatility (just as the individual components of the spread have).

Therefore, to maximize the risk:reward of the macro picture—the overall portfolio—traders should offset the risk of one spread with that of another (again, just like they do with the individual components).

Balance Risk:Reward

The goal of this exercise is to optimize the systematic options risk that must be spread to create an optimal balance of risk and reward. The overall portfolio has systematic risk of direction, time, and volatility.

If, for example, every spread has a positive delta, the trader can have a highly leveraged loss if the overall market declines. A trader can hedge off some of this systematic risk by having some spreads with long deltas and some resulting in short deltas.

A Mix

The technique is to find some stocks on which one is bullish and some on which one is bearish. The ideal outcome is that the trader is correct on both the bullish plays and the bearish plays. However, as the overall market (i.e., the S&P 500) rises, there is upward pressure on individual stocks to rise in sympathy with the market. Therefore, one would expect to make money on the long-delta plays and lose on the short-delta plays.

How It Works

But the premise here is that the strong stocks should rise more than the weak stocks in rising markets, resulting in a profit on the spread portfolio. This is optimized systematic risk. The same case can be made in a falling market. The weaker stocks—on which the trader has created a short-delta position—should fall more than the strong stocks, on which the trader has long deltas, when the overall market falls. Here, again, the spread portfolio’s optimized risk benefits the trader.

Time and volatility can be treated the same way. Many traders succumb to the siren song of positive theta—making money each day from time decay by selling options. Positive theta is a true benefit.

The Flip Side

But consider the other side of the coin: Positions with positive theta are hurt by volatility—when the underlying move results in a loss. If all of the trader’s spreads are theta beneficial/movement detrimental, a big systematic move in the market as a whole can result in a loss on all positions at once, creating a highly leveraged loss.

Don’t Lose with Time

The same case can be made about traders who are net long options. They have the benefit of leveraged profits resulting from volatility, but they pay for it with theta. If the market as a whole doesn’t move much, long-option traders can lose out on time decay on all their positions without reaping the benefit of movement.

Bottom Line

Therefore, traders should have some stocks that have positive theta (that are punished by volatility) and some that have negative theta (that benefit from movement). The technique here is to sell options on stocks that are expected to remain stable and buy options on stocks that should experience increased volatility. This eliminates the systematic risk of volatility in the market.

By Dan Passarelli of MarketTaker.com

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