Spread trading using options

Spread trading is a simple concept and using it with options involves combining two different options, as part of a limited risk strategy. The industry categorizes spreads as “complex trades”, like they wanted to keep traders and investors away from using them. As a result, the majority of options traded on the U.S. exchanges take the form of single options.

However, spread trading is not that “complex”! To build an option spread a trader uses two option contracts, known as “legs”. One is bought while the other one is sold. It can be both calls or both puts. It can be done for a credit or for a debit. Depending on the way you combine the two options, the resulting strategy can be bullish or bearish.

But maybe the most important reason why traders and investors use spread trading is that it reduces and limits risk.

Spread trading is a strategy and a risk management tool

What do you do when you are not willing to sell a cash secured put, also known as a “naked” put, due to its theoretical unlimited risk? You may sell a put credit spread instead. It involves the sale of a put and the purchase of another more distant put. The strategy is named a put bull spread and it’s a credit transaction; you receive a credit upon selling the spread and the risk is limited.

Spread Trading - Options Seminar - The EssentialsThe P&L graph of a Put Bull credit spread

For example, as SPX is trading right now for $2130, I may enter the following bull put spread:

-1 SPX 20Nov 2016 $2050 P
+1 SPX 20Nov 2016 $2030 P

and get filled at $4.00 for a credit of $400. Regardless of what SPX does after I enter this trade, the risk is limited to the difference between the two strikes ($2,000), less the credit ($400), which means $1,600.

How to trade with probabilities behind you?

A trade with a risk/reward of 4:1 may not look attractive to the novice investor, but the professional trader knows that probabilities stand behind him in such a strategy.

Aproximately 75% of the times the options in such spread expire worthless and he keeps the credit of $400. For the rest of the 25% times, he has very simple and effective management methods to turn the trade’s possible outcome in his favor, as well.

We designed such strategies and applied it to real SPX trades, as well as to other symbols, over the period 2014 – 2016 (up-to-date). It was only necessary to adjust on average three times a year, while putting on one such trades almost every week.