Amid the noise in the markets last week, Friday afternoon saw an interesting development, states Joe...
Bull Spreads: Same Profits, Defined Risk
10/03/2011 3:30 pm EST
Dan Cook explains how to use bull spreads, an option strategy that allows the trader to play either the long or short side of the market with fixed risk.
My guest today is Dan Cook to take a look at bull spreads. Dan, in this market that’s kind of falling apart, even the name “bull spreads” is kind of an oxymoron. Tell me about it.
It is, and the name can be a little bit deceiving. A bull spread can have a long bias or a short bias. So whether you think the market is going to go up, go down, or even stay range bound, there’s an opportunity to trade a bull spread.
How does it work?
Essentially, you’ve taken an option strategy, a vertical call spread, basically, but rather than having to worry about where the floor or ceiling is placed, we set those up based on the movements of the market.
We do multiple ranges each day. There’s a floor and a ceiling. So, for instance, maybe it’s 100 pips wide on a currency pair. So we might have a floor of 140 on the euro with a ceiling of 149. If I’m long, I typically like to buy close to the floor.
Here’s where the key is: because it’s an option, there’s no stop. One of the hardest things to do in currencies or any market is you can place a trade anywhere and you hear “manage your risk, manage your risk.” What that means to a lot of people is smother the market with a stop. Traders end up getting stopped out and all of a sudden they get frustrated, particularly the newer retail traders.
They get stopped out so they start moving their stop farther and farther away, or they just get frustrated and quit using stops, which is not good for anybody.
Not at all.
Because these are options—even though particularly in the volatile markets, which we see and we’re going to see for some time to come—if I have a long bias and I want to buy, if I’m buying close to the floor, so if I’m buying at 140.10 and the floor is at 140, even if the market drops all the way to 138 and then comes back, I’m never stopped out.
The key is my risk is fixed by the floor. So if the market takes a quick move against me that would hit my stop, I have time for it to bounce back up.
It is an options-type product. It’s a very simple strategy where it allows me to not have to worry about where I’m going to place my stop. I have limited risk and a limited upside, but again, it’s all about that limited-risk aspect. I know the risk going into the trade, the maximum losses I can take.
Why is it so important to manage risk?
Without money, you can’t trade, and that’s really the bottom line.
Often times as beginning traders, we see big moves in the market and we go, "Oh wow, if I had been on the right side of that I’d have made tens of thousands."
Really the key is when you’re looking at a move like that, say “If I was wrong, I was on the wrong side of that…” because it’s very easy to look back and think one way. If I was on the wrong of that, where would I have gotten out? How would I have managed my risk?
We don’t know if it’s going to move 20 pips against us, 50 pips against us, or 200 pips against us (or points, depending on the market you’re trading).
So by using an options-type product, if there is that quick volatility—particularly around economic announcements we see a lot of whipsaw action—a lot of traders want to get in on that because of the potential move.
With a bull spread, I can trade in that market, but I’m not whipsawed out because I don’t have a stop. Yet I have a unique combination where I can have equivalent leverage, because my risk is lower and that’s what I have to put up, so I can have equivalent leverage, I’ll call it, but I don’t have the stop in there where I can just get whipsawed and the trade is over in a matter of seconds.
So traders and retail investors should really consider bull spreads as a tool.
As a tool. They can be a very complementary tool to other strategies; they can be used as protection on an underlying position. A lot of different ways depending on how deep they want to get, but they make a very easy product to trade right away, and also, again, knowing all of the risk up front.
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