What are option spreads and how to trade them?

At stockguy22.com we get a lot of questions about how to trade options and how to trade spreads.

For those unfamiliar with a stock options, there are 2 kinds of options and 2 transactions that can be made. We will cover some option basics then talk about call and put spreads.  We won’t cover anything close to everything you can learn about options trading.

Option trading allows for a great deal of flexibility in strategies and limiting risk when used correctly.  Options can also give you huge percentage returns with proper position sizing for your own individual account.

Let’s get started with some background information.

 

Here are the basic options and order types typically available at most brokers.  One option contract is 100 shares of leverage of the underlying asset when you are talking about equities.

 

Option Types: Order Types
Calls Buy to Open (BTO)
Puts Buy to Close (BTC)
Sell to Open (STO)
Sell to Close (STC)

 

What is a long call? (Buy to Open)

An agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.

What is a short call? (Sell to Open)

An agreement that requires an investor to abide the obligation to sell a stock, bond, commodity, or other instrument at a specified price within a specific time period.  Short calls have unlimited risk when sold without owning shares of the underlying asset or as a spread with a long call.

What is a long Put? (Buy to Open)

An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time.

What is a short Put? (Sell to Open)

An option contract requiring the investor to abide by the obligation to buy a specified amount of an underlying asset at a set price within a specified time.  Short puts have a total risk of the strike price at which the short put is sold; meaning if the underlying asset would go to zero you are required to buy at the strike price while the market price of the underlying is zero, making what you now own worthless.

Sell to Close & Buy to Close

Orders that either buy to sell to close your position.

What is an option spread?

A basic long option spread is simply being long one strike and short another strike.  The max profit is the difference between the strikes minus what you pay for the spread.  So for example if you are long TWTR $65 Call and Short TWTR $70 Calls, you have a max profit of (65-70) $5.00 minus the cost to put on the trade.

There are both bull and bear call spread and bull and bear put spreads.  The long strike in relation to the short strike determines where its a bull or bear call, likewise for the put spread.

 

What is a Bull Call Spread?

A basic bullish call spread is an option position that has a long option at a specific strike and a short call option at a strike higher than the long strike.

For example, lets use TWTR.  Here is a chart of TWTR using the 15 minute time frame for the week ending Friday, December 27th.

You can see that TWTR shares went from $60 on Monday to a high of $74.73 by Thursday then ended the week at $63.18.

TWTR 15 min  - 12272013 - 02:18:15 PM

 

Using the underlying price of TWTR lets look at what the $65 and $75 December 27th Expiration Calls traded.

The first option we will look at is the $65 TWTR Call.  You can see on Monday the the $65 Calls were trading under $1, and by Thursday they were trading $9.5, then ended Friday worthless.

Why?  Because TWTR went from $60 to $74 and back to $63.

A call options real value at expiration is the directly related to the price of the underlying.  The $65 Call was worth $5 when TWTR was $70, and worth nothing if TWTR remained below $65 at expiration.

 

TWTR 65 C Weekly - 12272013 - 02:18:15 PM

 

Since we are making a spread let’s look at the TWTR $70 Call with expiration on December 27th, 2013.  On Monday the TWTR $70 Call was trading around $0.20, by Thursday it was trading $5.97, and ended worthless by Friday.

Why? For the same reasons the $65 Call started the week at $1 and ended the week worthless, TWTR did not close above the strike price for the Call.

 

TWTR 70 C Weekly - 12272013 - 02:18:15 PM

 

What is a Put Spread?

Put spreads, (Bear Put) follow the same logic as the Bull Call spreads except you are long a higher strike than the short strike.  An example would be if you were long the $65 TWTR Puts and Short the $60 TWTR Puts.  Max profit is $5 minus the cost of the trade.  If TWTR at expiration is trading over $65, then the trade is worthless and you lose the cost of the trade.

Remember the real value of a Put at expiration requires the price of the underlying to be below the strike of the Put, that difference is the real value.

 

What are the strategies?

You can use a few different strategies when trading options.  We will cover basic long calls (puts), non-legged spreads, and legging into spreads.

 

Strategy #1: Straight Long Calls or Puts

This is the simplest strategy when trading options.  You simply buy a Call if you are bullish or a Put if you are bearish.  For example, if on Monday you bought TWTR $65 Calls for $1 because you were bullish, by Thursday they were trading $9.50, but if you held until expiration they expired worthless.

Here is the TWTR $65 Call that expires December 27th, 2013.

TWTR 65 C Weekly - 12272013 - 02:18:15 PM

 

Strategy #2: Spreads (non-legged)

This is a slightly more complex strategy that lets you reduce the cost of a Call or Put trade but it limits the profit potential from infinity. You enter both the long and the short options at the same time.  Often trading platforms will execute a spread as a single unit to make entry and exit easier.

For example,  if on Monday you thought TWTR would rally during the week but you did not want to pay $1 for TWTR $65 Calls, then you could have purchased the TWTR 65/70 Bull Call Spread for around $0.60 to $0.80.

This means you are long the TWTR $65 Call and short the $70 Call.  Max profit is $5 (65-70) minus the cost (0.80), giving you a max profit of $4.20 if TWTR trades over $70 at December 27th, 2013 expiration.

Here is the charted value of the TWTR 65/70 Call Spread from Monday to Friday, December 27th, 2013.  You can see on Monday it was trading around 0.40 and by Thursday traded over $4, then ended the week worthless.

 

TWTR 65-70 C Spread - 12292013 - 10:25:33 AM

 

Strategy #3: Legging into Spreads

This strategy is the most complex we will cover but gives the most flexibility.

For example, a trader is an options ‘noob’ and doesn’t know anything but how to buy calls.  If they bought TWTR Calls on Monday and held to Friday, they lost on the trade.  If they found stockguy22.com and read about spreads, then they might have been able to profit from your trade.

So let’s say they bought (Buy to Open) the TWTR $65 Calls on Monday for $1.25 because they were chasing the traders and pumpers on twitter.com and social media.  Let’s also say they bought $1250 worth of TWTR Calls in thier $5,000 account; most new trades don’t understand appropriate position size for their account.

They are holding 10 TWTR $65 Weekly Calls expiring Friday, December 27th, 2013.  The traders are risking $1250 dollars plus commissions.  25% of their account !

On Tuesday those TWTR $65 Weekly Calls are trading $5.  You are now holding $5000 worth of TWTR Calls for a profit of $3750 or $3.75 per option contract.   That’s 300% profit on your position.  You still have your initial investment at risk if TWTR would decline to between Tuesday and Friday.  The traders are up over 50% on his account and are excited.

Here is where many traders make mistakes or get greedy.

They see on social media people saying TWTR is going to $80 or $100 and they should be long and just hold on. Since they are a stockguy22.com reader and subscriber, they know a little about market psychology and are skeptical when there is extreme exuberance.  They also know that round numbers can act as resistance levels and support levels, and the when a stock gets parabolic there will be sellers at some point.   They might even expect news and analysts to start commenting on how they feel about TWTR and those comments might not be positive.

What do the smart traders do?

Traders that understand a market doesn’t go straight up or down look at making this trade a Bull Call Spread by selling the TWTR $70 Calls, if they want to hold the TWTR $65 calls until Friday.  On Tuesday the TWTR $70 Weekly Call was trading $2.40, so we sell 10 TWTR $70 Weekly Calls for $2.40.  They take in a credit of $2.40 or $2400 ($2.40 x 100 x 10 – remember each contract is 100 shares and 10 contracts equals 1000 shares) from someone that was willing to buy TWTR $70 Calls.

Our account now has the following positions:

10 LONG TWTR $65 Weekly Call

cost $1.25 trading $5

10 SHORT TWTR $70 Weekly Call

cost $2.40 trading $2.40

COST OF TRADE:  +$1150 (-$1.25 + $2.40)

Remember when they bought the calls on Monday for $1.25 (-$1250)?   When they sold (Sold to Open) the $70 TWTR calls for $2.40 they received +$2400 in credit for selling them.  So if they spent $1200 on Monday and then received $2400 on Tuesday, what is the current cost for the TWTR $65/$70 Call Spread?

-$1250 + $2400 =  +$1150

Positive $1150 right?  That means this trade doesn’t cost them anything and the traders no longer have the $1250 initial investment at risk.

The traders have a max profit potential on the spread of $5 (65-70) and $1150 of guaranteed profit.

Therefore, if TWTR on expiration trades $70.01 at close, the $65 Call will be worth $5.01 and the $70 Call will be worth $0.01.  The TWTR 65/70 spread will be worth $5, and will settle for $5, plus the $1150 we took in on the $70 Calls – so our total profit will be $6150 or $6.15 per spread from an initial risk of $1250 for the long leg. After we entered the TWTR $70 Call short leg, our profit was a guaranteed $1150.

Total max return using initial risk:  495%

Total max return using spread risk:  INFINITY, since the trade was profitable no matter what happened, therefor we have no risk.  Either we made $1150 or we made $6150.

 

What are the drawbacks?

If TWTR trades over $70, they doesn’t make any more profit because the $70 call they are short will be increasing in value at the same rate as the $65 call they are long.  Can’t they just initiate another trade with the profits they have guaranteed? Yes they can.

If the initial trade does not go our way and they make a spread, they reduce the profit potential or even guarantee a loss.

Higher commissions for the total trade, you will have to pay for each leg.

 

What are the benefits?

The traders now have a trade they can’t lose on.  They will make $1150 if TWTR goes to $1000 or if it goes bankrupt by Friday.

They reduced capital risk and made guaranteed profits.

They can concentrate on other trades.

 

What really happened?

Let’s reference the 15 min TWTR chart and the 15 min chart of the TWTR 65/70 Call Spread below.   The first chart is the TWTR stock price and the second chart is the 65/70 Call Spread price.  As you can see TWTR gave up most of its gains after analysts and news picked up the rally and started talking about how it is over-valued.  If a trader held calls and got greedy, they lost 100% of what they paid.  If they did not leg into a spread they lost 100% of what they paid.  Only those that sold during the run up or those that legged into call spreads were able to salvage some of the gains.

The smart trader used spreads to offset potential high premium decay and reversal risk.  Even the non-legged spread buyer had the opportunity to make $3 on his $0.20-$0.30 spread risk.  The trader that legged into his spread had the opportunity to guarantee profits and reduce risk.

The basic call buyer could have made around $9.50 maximum if we was able to get out at the top, but its likely he had some stop to prevent a loss of his initial 0.40 to $1.00 risk.  While the spreads can reduce profit potential, the trade off is piece of mind.

Position size determines what risk to your future trading a losing position can have.  Straight calls, spreads, or legging into spreads all have risks and only you can determine what risk is right for you.

A stock doesn’t always move 20% in a few days, but stocks that do tend to retrace more often then they continue higher.

 

The roll out!

We didn’t covering rolling out options.  It’s relatively simple, you sell your profitable call or put and use part of that profit/initial investment to buy calls or puts that have a further out strike than the closed trade.  This technique locks in profits and reduces risk of losing profits when a move retraces.

Consider that if you bought TWTR $65 Calls on Monday for $1 then sold them for $8; you could have purchased the $75 or $80 calls potentially for a $1.  So you risked $1, made $7 (8-1), then risked another $1 on the $80 strike.  In the end you made $6 (8-1-1), since you only risked the same amount as your initial trade.  Sometimes it can be difficult to roll up in a stock that is moving fast and maintain reasonable risk and targets;  since everyone is running to buy calls to catch more rally then pricing can get inflated.

For the options traders that might poo-poo this basic summary.  There are many more factors and potential profitable trades to make on TWTR during this time period.  There was a large change in IV (implied volatility) during the week suggesting that the market may have under-priced TWTR volatility historically. The increased IV may have also had something to do with the TWTR rally, if the stock was squeezing shorts.

 

Position Sizing

I cannot stress how important having reasonable position size for your risk tolerance and account can be.  Let’s do some math.

If you get 500% winners then you only need to be right 20% of the time.  Risk $1 to make $5 means you paid $1 and sold it for $6.  That’s a $5 profit or 500%.

Let’s say you risk $1000 on each trade, you lose 8 trades in a row (-$8000), but make 500% on the next 2 trades.  500% means $1000 turns into $5000 profit and you have 2 of those trades for a total of $10,000 in profit.  Net profits are $2000 ($10,000 – $8000 = $2000).

If you have a $20,000 account then you just returned 10% on your total account with only a 20% hit rate.  10% a month is 120% a year !

 

If you get 300% winners then you need to be right 40% of the time.  Risk  $1 to make $3.

Same scenario as above except you lose 6 trades in a row, and make money on 4 of them.

 

See how important having reasonable position sizing can be?  It keeps you in the market long enough to have profitable trades.

Realistically your hit rate should be at least 50%, if it isn’t then contact us below for mentoring.

 

Conclusion

Legging into options spreads on stocks that exhibit high volatility can be a away to extend profits and limit risk.  Many times we fall victim to our own emotions regarding fear and greed.  Using spreads can help you maintain a consistent and profitable future.  Position sizing determines your risk to total capital no matter how you choose to trade.

Straight calls or puts can be very profitable but many times require a fast and constant move.  Turning a straight call or put into a spread is a way to lock in profits if you think the move might continue.

Spreads also work great on long term options trades where you might want to hedge out some theta (time) decay and some gamma (volatility) contraction.

There are many more topics to cover for trading options rolling options up or down, including implied volatility (IV), how to trade changes in volatility, and how to trade earnings events using options.

If you have any questions about options or are interested in mentoring by one of our options traders, please sign up for a free membership or use the contact form.

 

TWTR 15 min  - 12272013 - 02:18:15 PM

TWTR 15 min

 

TWTR 65-70 C Spread - 12292013 - 10:25:33 AM

TWTR 65/70 Weekly Call Spread Prices