Spread Basics

This is the fourth installment of Fujisan’s series on option spread strategies. I would like to take this opportunity to thank her again for sharing her extensive hands-on knowledge in this very arcane niche of the derivatives market. Incredibly, a large percentage of option traders only have a limited understanding of even the most fundamental option basics – it seems they quickly find their ‘comfort zone’ with the most basic linear delta/gamma (i.e. price) based trading strategies – as we humans usually have a tendency to do – and then rarely progress. However there is a vast number of advanced option strategies that go beyond simple price strategies and allow you to benefit from appreciation or deprecation of not just delta/gamma (i.e. price) but also theta (i.e. time) and vega (i.e. volatility).

Curiously, even a large number of long term traders know very little about how and when to facilitate option spreads to continuously and reliably produce profits over the long term. This is a very neglected (and often misunderstood) part of the option world and you are given a very unique opportunity to hone your skills and put them to work at the same time. Many traders literally pay thousands of Dollars on vastly inferior tutorials/seminars – plus you even have the chance to interact with the author right here to address various questions you might have.

Please show your appreciation to Fujisan for her considerable dedication and her time.

BWT – in case you missed it – evil.rat has been released – detailed announcement can be accessed by clicking on the image:

Cheers,

Mole

Why Option Spreads?

While the market is doing its regular routine (i.e., scare both bears and bulls), I would like to address the question that Mole brought up early this week, and I’m sure that many of you share the same sentiment.  He asked me why I bother putting a spread on if the market goes down and volatility picks up?

Here is my answer.  It’s all about YIELD, baby!

Let’s take a look at 4 different scenarios.  Let’s say that you pick up front month ITM, ATM, and OTM naked options and I pick up ATM spread and tell me which one you like the most.

Let’s assume that SPY is currently 85, and we are expecting the market to go down, and take a profit at 80.

ITM 90 Put Options

Here is ITM 90 April naked option.

Your investment is $5.90 and return is $4.10.  ROI is 69%.  ITM options are the way to go if you don’t want to deal with spreads.  Make sure that you pick up the strike price deep in the money so that time decay won’t affect you much.

ATM 85 Put Options

Here is ATM 85 April naked option.

Your investment is $2.94 and return is $2.06.  ROI is 70%.

OTM 80 Put Options

Here is OTM 80 April naked option.

Your investment is $1.31 and return, depending upon when SPY hits 80, would range from $1.71 to zero.  There is a higher probability that you could lose the entire premium of $1.31 by the time SPY hits 80.  ROI ranges from 0%~131%.

This is a trap that newbies tend to fall.  You see cheap options with potential higher return, but in reality, this “unlimited” return would never happen.

Here is how it goes.  You picked up this option with an intention of making a quick money, but the moment you get in, the trade started to go against you (sounds familiar?).  You don’t want to get out of the position until you break even, so you decided to hold on to your position.

A couple of weeks passed by, and SPY came back to your entry price.  In the mean time, you lost money on a time decay and got out of the position with a loss, instead of taking an “unlimited” gain.

Now, I’m not totally discarding this strategy.  There are particular circumstances that this strategy works quite well.

Remember the recent Oct 08 crash?  SPY moved more than 2 standard deviations in a matter of 2 weeks.  This is the time that OTM options works quite well.

Market crash, accounting scandal, bankruptcy filing — anything that would accelerate the deterioration would be a perfect situation to go with OTM options, but remember, market crash won’t happen every day.

85/80 Put Debit Spread

Here is my 80/85 April debit put spread.

My investment is $1.64 and return, depending upon when SPY hits 80, would range from $1.25 to $3.30.  ROI ranges from 76%~200%.  As you can see, once SPY passes the mid-point of the spread (i.e., 83), time decay (or I should say theta) starts helping me, instead of hurting me.  So, the longer it takes to get to 80, the more I would make money on theta.

Here is a summary chart:

Now that you have gone through four different scenarios, let me ask you this question.  Which position would you rather be in?  Spread is a clear winner!

Spread Basics

When you pick up a spread, the best position is to buy ATM and sell OTM options.  You sell the strike of your target.  Now, how do you pick the target?

I know many of you are good technicians.  You use fib, support/resistance, price pattern, and wave counts to come up with a target price.  But did you know that many spread traders don’t know how to read a chart, or they don’t even bother looking at a chart?  In fact, the better they are, the less they look at a chart.  This is because they go by different rules.

Just like you look at price pattern, moving averages, and momentum indicators to take the trade, spread traders look at probabilities, standard deviation, IV, and open interests.  Have you ever heard Dr. J or Peter Najarian talk about chart and momentum indicators?  All they talk about is unusual option activities and volatility, and that’s all they need.

Let’s look at SPY open interests.  I took this screenshot yesterday (April 24) after the market.  SPY close was 86.66.

Despite the bullish price movements of SPY on Friday, option activities remain bearish.  The majority of market participants expect SPY to pull back to 80~78 level.

Look at open interests.  I see pretty good open interests at 85, 82, 80, 78 —, wait, aren’t these strike prices matched up with fib and resistance level?   That’s right.  Without even looking at a chart, open interests are already telling you the market’s expectations and where to take a profit, because “spread traders” would sell the shorts at their targets!

If you like to be a good option trader, sell the strike price with large open interests.  Unless you are self destructive enough to sell naked options, you should always buy one leg to sell another.  You can do this with various spread combinations, and vertical spread is a first step to be a good spread trader.

Setting up a realistic expectation

I know, another reason that naked option traders won’t trade spread is because you don’t want to “limit” upside potential by selling higher strike price.  But when was the last time you actually recognized those “unlimited” returns?

In addition, we should make a realistic assessment of the current trading environment.  We have just gone through 6 weeks of upside impulsive wave.  If we expect 38~50% price correction, same goes with time dimension.  We should expect at least 2~3 weeks of zig zag corrective waves.  You like to put theta on your side so that you could sit back and relax while the market is going through consolidation.

NDX Short Idea

I just came across a perfect short scenario with NDX.  Here are my assumptions:

1. Double top
2. Price rejection at today’s high at 200 SMA.
3. a=c pattern formation complete
4. W3 complete
5. Negative Divergence in Oscillator

We still have to wait until Monday to confirm my assumptions, but if it works out, this would be a perfect short candidate and good for a spread trade.

Here is NDX 1375/1400 call bear spread.  Stop at 1381.

As NDX is not as active as QQQQ, I would normally trade QQQQ instead.  Here is QQQQ 34/32 put bear spread.  Stop at 33.96

I hope you enjoyed my weekly update.

Thanks for spending your weekend with me.

Fujisan