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Spread Trading

Hello Mark, and thank you for your kind help.

I would be grateful if you could answer a few follow-up questions.

1a. I am intrigued by the concept of bull put spreads – thank you for bringing them to my attention. Since you seem to prefer them over bull call spreads, could you briefly explain why? Is it just because in the case of the former time decay works in one’s favor and that profits can be retained even if the stock stays steady, or is there something more to them?

I do not prefer selling put spreads to buying call spreads BECAUSE they are equivalent. It makes no difference which you trade. Each spread has the same time decay. The spreads are essentially identical, even though they appear to be different. When you are ready, take this lesson: Equivalent positions.

Understand that some traders are more comfortable collecting cash when entering into the trade and then they can (when it works) watch the spread value decline towards zero. Others are more comfortable buying spread because they know the cash [paid represents the maximum possible loss and they will never have to pay an money to get out of the position. NOTE: The maximum possible loss when selling the put spread is identical, but some are more comfortable when the cash has been paid upfront. It is all psychological and truly makes no difference.

If you are a new option trader (as your questions suggest), then choose the trade that you want to make. If looking at the trade from the buyer’s perspective makes you more comfortable, then buy the spread. As you gain experience, you will come to recognize that it really does not matter whether you buy a call spread or sell a put spread as long as one thing is true: The options must have the same strike prices and expiration date. That is iron clad. Change anything and the positions are no longer identical.

1b. Would you say that the optimal way of specifying the strike prices of the relevant puts is to make the strike price of the short one correspond to the level we believe the stock can reach and the strike price of the long one to a point somewhat below the nearest major support level?

No. Let’s be honest: Neither you nor I know where the stock price is headed. More importantly, your goal is to make money — it is not to be exactly correct on your predictions.

If a stock is priced at $100, you may want to buy the $100/105 or $100/110 call spread [or SELL the $100/105 or $100/110 put spread]. These should earn a profit when the stock rallies, but will lose money if the stock price does not budge, or when it rallies by ~$1. That’s not good enough for me. I want to make money even when I am not as correct as i expected to be.

Therefore, I’d prefer to buy the $95 calls and sell the $100 calls (or buy the $95 puts and sell the $100 puts). Noe I make money even when the stock does not rally. That’s good – but there must be a downside to making this trade — and there is. If the stock price tumbles, the $95/100 trade will lose more money than the $100/105 trade [If you do not know why, then I recommend starting your option education at the beginning and not try to jump in at this level.] Sure, you want to avoid the larger loss, but if you have any confidence that the stock price will increase, then you ought to have even more confidence that the stock price will not move lower.

Choosing the specific spread to trade is important — but please: it has nothing to do with your predictions unless you have a wonderful track record of successful predictions. One trade risks losing more, but comes with a higher probability of success. The other comes with the chance to earn more money, but with a lower probability of success. Choose whichever spread appeals to you more. You are the mast of your own risk-tolerance universe.

1c. Would you say that it is worthwhile to close out a bull spread (be it call or put) as soon as the predicted upper price level is reached, regardless of how far away one is from expiration?

I think you know the answer. If the stock rallies and reaches your target price, then you clearly do not expect it to move higher. So, why would you want to own a bull spread when you do not expect the stock to move higher? Yes, exit. Expiration has nothing to do with this decision.

I note that you said “upper price level” and not your target price.

If your question is really this: “I buy call spreads. Should I exit as soon as the stock hits the upper strike price?”

Then my answer is: “NO.” If you make a trade and have a profit target for your spread in mind (rather than a price target for the stock), then exit when you earn the profit. It does not matter what the stock price is. You will not want to choose the strike prices such that you expect “the upper level” to be reached. You should pick spreads than you believe will make money. That is the primary goal for a trader. You must remember that if you expect the stock to rise from 75 to 85, do not buy the $80/85 call spread. If the stock rallies, but only gets to 79 or 80, you must own a spread that earns a profit.

1d. Am I right in thinking that the margin requirements for any given bull spread (be it call or put) essentially correspond to the amount of cash one has to put up when assigned, so, for instance, if one sold 2 contracts with the strike price of 40, then the required margin is $8000?

NO. When you buy a spread, there is zero margin. You just pay for the spread. When you sell a credit spread, the margin represents the maximum possible value for the spread, but you can use the cash collected to meet some of that margin requirement. If you sell a naked put option, that is where the Reg T margin requirement is essentially the cash required of assigned an exercise notice. But it is reduced by other considerations, including how far OTM the strike price is.

2. You said “If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options.” Am I right in thinking that what you mean is that you are happy with committing more of your portfolio to option positions provided that they are tied up with non-directional strategies?

Yes. When my positions are much less risky than owning calls, and when they are hedged, I am willing to place more money into option positions. But please note: That is my personal comfort zone and it is NOT a recommendation for anyone else.

3. And, finally, one very different question – are you aware of any free software/website that displays not only unusual options activity, but also shows the list of biggest daily transactions and indicates whether the options involved were bought at the ask or sold at the bid? I know that thinkorswim offers this function, but apparently you need a TDAmeritrade account to use their software, and since I’m not US-based, I don’t think that I can access it.

No, I do not. Nor do I like the idea of using that information. It is 100% useless to you. Yes, 100% useless. So what if you know that someone buys 10,000 calls for a given stock? What does that tell you? It does not tell you whether this is a new position of if the buyer is covering a short position. It does not even tell you whether the trader is making a bullish play because there may be another part of the transaction that you cannot see. For example, if he buys 10,000 ATM calls and sells short 500,000 shares, then he owns a market-neutral position equivalent to owning 500,000 straddles. And if he sells short 1,000,000 shares, then he essentially bought 10,000 puts but to the casual observer it loos as if he bought 10,0000 calls.

One more point, even if you do know whether this big buyer is bullish or bearish, or neutral, what do you know about his track record as a call buyer? Nothing. Acting on this type of information is foolish.

Once again, thank you for your time – I really learn a lot from you and greatly appreciate your expert help.
Best wishes,
Jakub

My pleasure.

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Options can do great things for investors

Imagine that you never heard about options. Assume that you fancy yourself to be a good stock picker and market timer. You often repeat a trading slogan: “Have a hunch? Bet a bunch.” The results are pretty straightforward. If your hunch was correct, you get to sell your stock at a profit. If incorrect, you usually take a loss, but may break even.

That was the life of an equity trader in the good old days (before 1973 when listed options began trading).

The Options World

Option traders can adopt the same strategy and buy a bunch of calls or puts when they want to play a hunch. The results are often as expected: stock moves in the right direction, earn a bunch. Stock does not do as expected; lose a bunch.

But that is so inefficient and (in my opinion) a silly way to trade options. One of the fascinating things about trading hedged option positions (spreads) is that you can make money, even when you are wrong.

    EXAMPLE
    — XYZ is $58 per share.
    –You are bullish and expect the stock to move past $60 over the next month (two months, tops).
    –Instead of buying calls, consider selling a put spread.
    –Sell the 2-month 50/55 put spread, collecting an $80 premium.
    –If the stock moves higher, the spread expires worthless and you keep the whole $80
    –If the stock remains stuck near $58, you win again as the options expire worthless.
    –If the stock price moves lower (not what you expected to happen), you are a winner if the decline is not too large.

Imagine earning a profit when your prediction is incorrect! It is a wonderful feeling to know that you do not have to predict the future to earn money.

Of course this trading style (credit spreads) has drawbacks. Profits are limited to the premium collected. If the stock undergoes a good-sized rally, that will be a disappointment. All traders like the opportunity to earn a large profit. To offset this negative feature (limited profits), the put spread seller earns a profit far more often than the stock or call buyer.

I love the trade-off: Limited profits in return for more frequent gains. The other great advantage of selling the put spread is that losses are limited. This is not something that occurs to bullish traders, but this $58 stock may be trading below $50 tomorrow. Spread traders are never exposed to unlimited losses. If your trading history has always consisted of buying options, consider trading spreads.

This is the heart and soul of trading put credit spreads. It is much easier to find a stock that does not decline below the put strike price than it is to find a stock whose price will increase.

Let me repeat that: It is easier to find a stock that will not decline than it is to find a stock whose price will increase. In traditional investing, the traditional path to profits is to buy something that increases in value. When selling put spreads, a rally is appreciated, but it is not needed to earn a profit. This is an eye-opener for the novice trader.

http://goo.gl/lZXELu

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Vertical Spreads II

This second lesson is still directed to newer options traders and explains (in extra detail) call and put spreads.

  • looking at the current market price
  • delta as a probability
  • what is the maximum value of a call (or put) spread
  • choosing among alternatives – introduction.
  • more on this in part III

Free sample of Options for Rookies Premium: Find the video here:

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Vertical Spreads

Note to Option rookies:

    –Do not avoid spreads.
    –Do not believe they are too complex to understand.
    –Spread trading offers advantages over trading individual options

The vertical spread is as basic as them come:

    –Buy one call and sell another; or buy one put and sell another
    –Both options have
    –the same underlying asset
    –the same expiration
    — different strike prices

Without further ado, here is a link to the video on vertical spreads

Alert: This topic is covered in a very different manner by most books and mentors.

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Trading Spreads

Once beginners discover that buying options is not a game they can conquer, they slow down and look for better trading ideas. At the top of the list of better ideas is the spread.

A spread is a position with two different options. The trader buys one and sells another. This is not at all complex, yet many educators don’t get around to teaching spreads until they consider the trader advanced enough to grasp the concept.

That does not work for me. I encourage traders to learn to use spreads as early in the game as possible.

I recently posted a video for people who are first thinking about trading spreads. It can be seen here.

I’ll soon return with at least one more new video lesson that covers vertical spreads. Those are spreads with options that expire at the same time. They are used for bullish, bearish and neutral strategies.

Trading spreads improves results in one of these ways:

    –**more frequent profits** (profits are limited, but this is my favorite reason)
    –smaller and limited losses (not all trades go our way)
    –reduced cost to play your market expectations

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