Use of Options Spreads to Reduce Risk

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.