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Trading Options Spreads - in Theory and Practice

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Options can be a great tool to take long or short positions in the markets, but they have different risk/reward characteristics than simply taking a long or short position in the underlying security. Owning an option allows us to participate in the price movement of a stock, while limiting our exposure to a move in the opposite direction. The owner of a call option participates in the upward movement in the stock while risking only the price of the call; the owner of a put participates in downward movement in the stock with only the price of the put at risk. (The price of an option is often referred to as the “premium.”) The seller of an option has the opposite risks and rewards, collecting the premium but potentially paying out a huge sum (the amount is technically unlimited in the case of short calls), if the underlying moves adversely.

What is a Spread?

Broadly defined, an option “spread” is the simultaneous purchase and sale of two or more options for a total net price. There are three main reasons to trade a spread:
1)    It allows you to further customize the risk/reward profile of a trade, in many cases both the maximum profit and loss on a trade can be known with absolute certainty.
2)    It is often less expensive to execute (in terms of friction from the bid/ask spread) than trading the component options individually, and
3)    It can allow us to take advantage of the fact that due to supply and demand issues, options on the same stock are sometimes not priced uniformly.  That is, they have different implied volatilities, making them more/less attractive relative to each other.

It will generally be my intention to design option trades as spreads that take advantage of all three of these reasons, allowing us to take a bullish or bearish position in a stock while limiting risk and taking advantage of different implied volatilities observed in the market prices for options.
Implied Volatility – a Quick Primer

A model for pricing an option uses five inputs: The current price of the underlying, the strike price of the option, the amount of time until the option expires, the risk-free interest rate and the expected volatility of the underlying. Notice that you can be certain about the first four inputs – they are facts – but the fifth, future volatility, cannot be known for sure. The trader has to make an estimation of what volatility will be. Conversely, if you observe the price of an option in the marketplace, you can deduce what the market is using for its estimation of future volatility. The market price implies a certain volatility, hence the term “implied volatility.”

Why Do I Care About Implied Volatility?

The greater the estimate for future volatility in the underlying stock, the more the options are worth, all else being equal. This stands to reason – the more a stock moves, the likelier it is that any given option will end up in the money at expiration, so it’s worth more now. If you pay attention to implied volatility, you can determine which options are cheap or expensive relative to each other and you can construct spread trades that take advantage of the difference by purchasing a less expensive option and selling a more expensive one. (Note: There is a legitimate mathematical reason why options at different strikes but on the same stock and with the same expiration date can and do trade at different volatilities, but I’ll save that explanation for another day.)

How and Why Do Implied Volatilities Change?

Implied Volatilities - and thus the prices of options - can change in response to news about the stock, news about the market in general or actual movement in the stock, but they can also move in response simply to supply and demand for the options. When a big institutional customer purchases a large amount of a given option, the market makers who sold the options will generally raise the volatility estimate in their models for the options they sold and other options that are similar. The reason is that now that they have a short position, they’d like to buy it back, so they’re willing to pay a higher price than they were before. If they’re going to sell more of those options on the next trade, they’d only be willing to do it at a higher price - and thus a higher implied volatility.

How Can I Use Implied Volatility to Construct a Profitable Trade?

Here’s an example:  Let’s say stock ABC is a Zacks Rank #1 that you’re considering purchasing for your portfolio. You want to hold it for a certain period, like through the next earnings release a month from now. (Remember that because they have a limited lifespan before they expire, options are best used for specific short-term trading ideas rather than long-term investing.) If a large trade happened in which an institution bought 15,000 out of the money calls, it’s likely that the implied volatility and the price of those calls would rise more than other call options at different strike prices.

So now you have a few pieces of valuable information. You already had a Zacks #1 stock that you were considering buying. Now someone else is bullish too, at least enough to buy a lot of calls (obviously, just because the order is big doesn’t mean that trader is right, but at least someone "in the know" is supporting your long thesis.)  Finally, there’s now a call strike that’s suddenly more expensive than it used to be.

You buy the at-the-money call and sell the out-of-the-money call that’s trading at a higher volatility. You have constructed a spread with limited downside risk – your maximum loss is the premium you paid for the long call minus the premium you collected on the short call. If you’re right about the stock rallying, you profit, and you got into the position at an attractive price because you did it with an awareness of the implied volatilities.

Something along these lines happened in Vmware(VMW - Free Report) yesterday, though the call was so far out of the money that it didn't make sense to sell it in a spread.

This is a somewhat simplified example, but it’s indicative of the kinds of situations I use to construct options trades. Stay tuned for specific trade ideas as they occur.

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