Option Spreads Examined Further: Measured Ways to Play Your Market Hunch

New option traders tend to overlook the strategy of combining two options to form spreads, which allow different degrees of market optimism or pessimism.  Option spreading is different than futures because a straight futures play only portrays one degree of bullishness/bearishness.  If one is long the futures, he better be very sure the market is going up from the moment he is filled on the position.  Sure, there are risk measurement tools we all use to make sure we don’t lose the farm, and no one can always picks the exact top and bottom, but when it comes down to analyzing trade setups, there is no reason to buy or sell a futures contract unless you have a strong conviction the market is going to go in the direction you think it will immediately.

Unfortunately, many traders have a hard time garnering that much conviction.  Some see various degrees of bullishness or bearishness in the marketplace, either due to fears of certain economic events or sentiment changes in the marketplace.  Therefore, they can’t bring themselves to buy the futures outright.  If this is the case, then a bull call spread or a bear put spread may be a better way to capture gains.  (If you have been a follower of this blog you should be familiar with these spreads, if not you can read the articles on bull call spreads and bear put spreads to get the basics behind each strategy.)

The Structure of the Spread is Very Important

When applying these strategies, the amount of bullish/bearish sentiment can be measured by the difference between the option bought (closer to the money) and the option sold (further from the money).  It is very important to have a specific plan in place; just picking arbitrary strikes will affect the risk/reward potential.  In options trading always apply the adage, “there is no such thing as a free lunch”.  That means the more you pay for the spread, the higher the profit or loss potential.  When placing a spread trade it is important to be careful about the strikes chosen, the trade setup should reflect how bullish or bearish you are.

When you place the option sold closer to the option purchased, you will lower the cost of the spread, but by doing so you will lower the spread’s earning potential.  If you place the option sold further away, you may have the opportunity for big gains but you are risking more to realize those gains.  The spread between the prices of different strikes will be determined by a few factors, but to make life easier I like to look at the difference in market delta between the option bought and option sold as my primary indicator (learn more about market delta).

A good rule of thumb trader’s use is called the “.20 to .30 delta rule.” This rule implores the trader to look at the deltas of each option, subtracting the delta of the purchased option from the delta of the sold option.  Ideally the difference should come out to be somewhere between .20 and .30.  The closer to .20 indicates that the spread is on the conservative side, the closer to .30 indicates it is on the aggressive side.  Sure, you can buy spreads with higher and lower deltas than .20 and .30, but in those cases bear put and bull call spreads may not be the best strategy.  Keep in mind these deltas change daily, it’s important to have this data handy before executing the trade.

Compare Plans

Trader Ann is bullish gold.  She believes that over the next two months the market will see a price appreciation of somewhere between 4% and 7%, but due to the uncertainty of the Federal Reserve policies and the European debt issues she worries she might have to whether some volatility in the meantime.  She believes picking tops and bottoms is a loser’s game, and knows she doesn’t have the stomach (nor the wallet) to afford a futures contract outright.  At of the close of the market today gold is trading at 1525, which would place her target anywhere between 1585 and 1620.  She has $10,000 dedicated to her trading and doesn’t want to risk more than 30% of the liquidity in her account on the trade.  Because she has a two month timeframe in mind, we will look at the August Gold calls that expire in 60 days.  For this example we will look to buy an “at the money” call and sell an “out of the money” call at one of the strikes mentioned above.  Ann will call her Daniels broker and price out a few different plans and decide which is best for her.  Let’s compare our two plans and see which one is more appropriate:

Plan #1
1525-1585 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1585 Gold Call for $2000 with a delta of .30.
Total premium paid for the spread is $2100, which will initially trade with a delta of .21

Max profit= $6000 (total gain between 1525 and 1585) – $2100 (cost of spread) = $3900
Max loss= $2100 (cost of spread)

Plan #2
1525-1620 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1620 Gold Call for $1300 with a delta of .21
Total premium paid for the spread is $2800, which will initially trade with a delta of .30

Max Profit= $9500 (total gain between 1525 and 1620) – $2800 (Cost of spread) = $6700
Max loss= $2800 (cost of spread)

Ann can now see by looking at the delta comparisons, how much she will make or lose initially from the option spread as the underlying futures prices move higher or lower.  The larger the delta on the spread, the more profit/loss she will take from a one point move in the August gold futures contract.  Based off these numbers she can apply them to her level of bullishness in Gold.  If she believes the market is more susceptible to an immediate move up she will enter the market via Plan #2.  If she feels a little apprehension about the short term prospects of gold she would probably be better off entering via plan #1.  Keep in mind Ann wants to participate now, she doesn’t want to try to perfectly try to time an entry.  Either way, she will get the exposure to the gold markets immediately, allowing her to handle the market swings as they come.

If she is correct and the market moves higher she will profit, if she is wrong and the market moves lower she will lose, as any directional trades result.  But Ann is more focused on where Gold will be in August and not today.  She obviously would rather be correct sooner rather than later, but as we learned about these spreads from past articles, they allow for the market to do its thing without worrying of a margin call.

As always, leverage cuts both ways and it is important to know exactly what you have on the line with each trade.  The way you establish these spreads should reflect your market sentiment.  If you have any questions on the strategies mentioned above or finding the delta on specific options please contact your Daniels Trading broker.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

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HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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