Friday, 25 March 2016

HOW TO TRADE A SPREAD

THE BASICS
Options are special. They are unlike other investments because they were invented (circa 600 BC) as a tool for reducing and managing risk. In other words, one person (the option buyer) pays for the right to transfer a specific risk to the option seller. The seller charges a fee (premium) and agrees to take on that risk in return for the cash.
Think of put options as being similar to an insurance policy whereby an investor can guarantee the value of a specific investment by purchasing a put option. As a reminder the put owner has the right to sell the underlying asset at a specific price (the strike price) at any time before the put option expires, thereby eliminating any further loss when the stock price is below the strike. That is very similar to how an insurance policy works. (If your house burns to the ground, you can sell it to the insurance company for the insured sum.)
When dealing with call options, in return for paying a premium to buy the option, the buyer gains all upside movement (above the strike price).
The seller accepts the risk of losing a large sum if the stock price surges. For example, if you sell the right to buy 100 shares of a given stock at $50 per share to another investor, then you must deliver that stock if and when the call owner elects to exercise his/her rights. If that stock is trading at $70, you must buy stock at $70 and sell it to the call owner at $50. That is a loss of $2,000 (minus whatever sum you collected when selling the option).
THE SPREAD
it is possible to gain protection against losing a large (essentially unlimited) sum when selling options. The way to do that is to trade a spread, rather than just selling calls or puts. The spread is a hedged (risk-reducing) position. Let's see how it works.
In addition to selling the call option, per above, let's assume that you also buy a call option on the same underlying stock, with the same expiration, but with a strike price of $55 per share.


The Trade (using options that expire on April 15, 2016)
Sell 1 XYZ Apr 15 '16 50 call
Buy 1 XYZ Apr 15 '16 55 call
 At first glance, this appears to be a foolish trade. After all, the only reason that you want to sell the Apr 50 call option is that you believe that this stock has little or no chance of moving as high as $50 before the option expires. If that is your belief, it seems wrong to buy the right to own stock at $55 when you believe that there is no chance for the stock to move that high prior to expiration.
The traditional call option buyer expects the stock price to rise, thereby increasing the value of the call. However, you are not buying the Apr 55 call option as a bullish trader. Instead it is bought as a hedge. It is bought solely to reduce the risk associated with being short the Apr 50 call.

It is important to understand the subtle difference. You did not buy the Apr 55 call because you are bullish. It was bought as a hedge. You sold the Apr 50 call because you are bearish on XYZ and only bought the other call as a hedge.
It is important to look at the big picture. What you really did was to sell a call spread for a net cash credit. Therefore it is important to consider the spread as your investment and not be concerned with the fact that it is composed of two different options. When examining risk (the amount you can lose), notice that the maximum loss has been reduced to $500 (minus the cash collected from the option trades) and is no longer unlimited.
If you do sell this spread, and if the stock does rise to $70, you lose the maximum possible amount from this position. You must sell 100 shares at $50, just as when you sold the naked call option in the first example. However, this time there is no need to buy stock at $70 because you own the Apr 55 call and that gives you the right to buy stock at $55. Thus, you exercise your call option (paying $55 per share) and deliver those 100 shares to the owner of the call option, collecting the strike price, or $50 per share. The loss is $500 (less net premium collected).
And that is all there is to it. When selling options, do so with far less risk by selling a call or put spread instead.
There is a large number of spread strategies available to option traders. The primary purpose of spreads is risk reduction. In this example, the spread limits losses. In other examples, spreads can reduce the cash required to make an investment, again limiting losses.
NOTE: Profits are also limited when using spreads, but for most conservative traders, that is an excellent trade-off.
Options are your friends and it is important for every option trader to understand the basics of trading spreads.

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