SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Use of Options Spreads to Reduce Risk


Traders may view spreads as a means for reducing market risk. But this also means that the potential profit is just as limited as potential loss, and this is easily overlooked in the focus on risk alone. A realistic view of spreading is that it reduces risk in exchange for accepting limited maximum profit.

As a result, traders using spreads are willing to accept some relatively small losses, while being exposed to equally small relative profits.


The spread, by definition, involves taking offsetting positions at the same time and on the same underlying security. Spreads come in many variations, but they have basic features in common. They may also be weighted, so that one side or the other poses less or more risk. When this kind of position is opened, it is not strictly a spread. It consists of a combination of a spread with a short or long stand-alone position. Traders may convince themselves that this is a sound method for continuing to reduce risk or maximize profits, but in fact weighted spread positions cannot be equated with the one-to-one basic nature of a simply spread.


Too often, traders come to expect a profit, even a small one; but they do not expect to suffer a loss in any conditions. This is not realistic, because the possibility of gain is equal to the possibility of loss and assuming that only the positive outcome will occur is not rational. It may be termed the “gambler’s dilemma,” because the only acceptable outcome is profit. If a gambler plays roulette and bets only on black or red, it is apparent that nearly half the time, they will win. The use of the word “nearly” recognizes that zero and double zero reduce the odds of 50/50 outcomes fort black and red. There are 38 possible numbers, but the payout is based on red ore black. If half of the assumed outcomes are red or black, the formula to determine the odds is:

                                18 ÷ 38 = 47.4%

 

This means a player will win 47.4% of the time. The payout is 36 to 1, but the number of possibilities is 38. It is not 50/50 as many people assume, so if you play roulette often enough, you will lose at a probability rate of 2.6%.
 

Applying this brief probability exercise to a spread, are there factors affecting the 50/50 relationship assumed to exist between profit and loss? Yes. In a 1-to-1 spread, what are your true odds? When you factor in the trading costs alone, you must realize that a 50/50 outcome results in a small loss over time. To break even, you would need to realize profits better than 50/50 just to break even.


This disadvantage can be overcome in some ways. For example, picking spreads based on historical volatility and a pattern of price movement, you might be able to anticipate price movement and even direction. It is a guess, just like playing roulette where the house always has an advantage. But with spreads, analysis may reveal a pattern occurring just before ex-dividend date, on or immediately after earnings announcements, or as expiration date approaches. Taking advantage of  time decay also improves changes for profit in short sides of a spread.

For example, one week prior to the last trading day, a significant reduction in time value takes place, because time decay occurs on weekends as well as weekdays. Between the Friday one week before last trading day, and the next trading day (Monday), on average one-third of time value declines. It is even greater when Monday is a holiday and the market is closed for three days. This observation makes short-term spreads more interesting, especially if short premium is richer than the corresponding long premium. The decline in time value may create an immediate short-term profit due solely to time decay, and possibly high enough to offset the net cost of the overall spread position.


The potential profit (or loss) will also vary between vertical, horizontal, and diagonal spreads, not to mention weighted spreads. For short-term horizontal spreads, for example, setting up a weighted ratio favoring the short side contains risk, but with time decay, it can greatly enhance potential profits. An experienced spread trader can manage risk by selecting the most advantageous strikes and spread relationships, not to mention the underlying. An issue with high premium is more volatile than average, and for many this means opportunity is great. But so is risk. It is not good risk management to pick options based on richness of premium, because this ignores the role played by volatility. Greater volatility translates to greater risk.


From a speculator’s point of view, spreading is not an exciting strategy. It is much more exhilarating to have the potential for a large and fast profit, but a smart speculator also knows that an equally possible loss applies. The mistake some speculators make is forgetting to analyze the likely outcome, or simply excluding the possibility of poor timing and eventually, of loss. For those who have tried speculating on options (and most traders have done so to some degree), spreading offers a possible solution. Are you interested in consistent but small profits? Or do you seek the excitement of untold wealth from a string of well-timed trades? Some speculators are happy to risk possible losses, to have exposure to fast and large profits. Most speculators end up losing because timing is not perfect.


The same observation applies to gamblers, of course. It is not likely that anyone has been able to beat the roulette wheel or the craps table consistently. However, when you speak to gamblers or to options speculators, you are likely to hear about the fantastic profits they took in yesterday … but they do not boast about the even greater losses they had the day before.
 

Yes, spreads are unexciting, but they serve as a risk management tool. The edge is gained through observation and timing of market conditions (dividends, earnings, and expiration as well as the volatility and trading pattern of the underlying) and knowing how to trade based on those observations. The alternative – speculating means taking greater risks and, in most cases, losing more than winning.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
 

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Should You Finance or Pay Cash for a Home?

    When buying a home, individuals who have accumulated enough wealth to pay cash or make a substantial down payment have a decision to make. Take advantage of record low interest rates and lock in a 30-year mortgage for around 2.5%? Or pay cash and make payments to yourself by investing the savings?

    By Jesse,

    • 0 comments
    • 52 views
  • Implied Volatility Collapse

    The key ingredient on expiration Friday is volatility collapse. At the beginning of that last trading day, there are more than 6 hours of trading yet to go. However, there are 38 hours left before expiration on Saturday. When volatility is high, OTM options are most likely to be overpriced.

    By Michael C. Thomsett,

    • 0 comments
    • 160 views
  • Trading Volatility: Why It Isn’t Always a Bad Thing

    Volatility is still widely misunderstood — and feared — by novice traders. As someone lacking in trading knowledge and experience, you often hear and believe horror stories of unstable markets. The fear is valid. After all, your shares and investments are at an elevated risk in an unpredictable environment.

    By Kim,

    • 0 comments
    • 159 views
  • Models and their limits

    Options traders tend to think mathematically. When considering selection of an underlying, risks and expected profits, the model of outcomes is a primary tool for making selections. Without a model how can anyone understand the differences between two or more options that might otherwise appear the same – similar moneyness, same strike, and same premium.

    By Michael C. Thomsett,

    • 0 comments
    • 168 views
  • When You've Only Got $1000 To Invest, What Do You Do?

    Are you new to the world of investments? Most likely; it’s not something you just fall into! BUt at the same time, investing can be done by anyone. Investing doesn’t need to be saved for retirement. It isn’t something only the uber rich are able to get into.

    By Kim,

    • 0 comments
    • 387 views
  • Use of Options Spreads to Reduce Risk

    Traders may view spreads as a means for reducing market risk. But this also means that the potential profit is just as limited as potential loss, and this is easily overlooked in the focus on risk alone. A realistic view of spreading is that it reduces risk in exchange for accepting limited maximum profit.

    By Michael C. Thomsett,

    • 0 comments
    • 460 views
  • Put Writing in 2020: The Role of Timing Luck

    The impact of luck can play a meaningful role in the short-term outcomes of monthly option trades due to the requirement to roll expiring contracts. The extreme volatility in 2020 highlightsthis fact when we look at results of SPY cash secured put trades launched on slightly different start dates.

    By Jesse,

    • 0 comments
    • 466 views
  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 632 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 526 views
  • Do Options Affect Stock Prices?

    It is widely acknowledged that the price of the underlying directly impacts the premium of the option. Therefore, options are termed derivatives. Their current value is directly derived from movement of the underlying price. Is the opposite also true? Does movement of the option value affect the underlying price?

    By Michael C. Thomsett,

    • 0 comments
    • 783 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido