Low Risk Options Trading Strategy - Option Spreads

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AW10

Well-Known Member
#1
I am starting this thread to discuss low risk options trading using a strategy called Spreads.
We have threads in TJ discussing other strategies that in my view both are risky strategies (short straddle, buy naked call put etc) and should be avoided at early state of options trading.
I also started with Buying Naked call options but later I realised that there are better low risk strategies available - which are Spreads.
So starting this thread to discuss SPREADS.. Now I advise any new option trader to start with this till they gain real experience with options and ready to take more riskier trades.

You might be in for some surprises here by knowing
- that you can use PUTs to take bullish position and can use CALLs to take bearish position.
- that time decay can't hurt u
- that market can pay you partially for taking a trade and reduce your risk
- that you can execute trades with very high probability on your side and generate regular income
- that you can play go against market (contrarian ) with very limited risk
- that you can have a position in the market which has leg is 100% winner.

Looking forward for experience from others to answer the doubts raised.

Happy Trading.
 

AW10

Well-Known Member
#2
What are Spreads ?Spreads are Limited Risk / Limited Reward strategies. They can be constructed using either PUT or CALL options.
They are directional strategy - Bullish or Bearish
It involves 2 options trades - Buying Option at 1 strike and at the same time selling another option at different strike price.
(note if you are shocked that it involves selling option and I am newbee. Everybody tells that stay away from selling options.. Then you got to read further. Soon u will start seeing the advantage of
spreads over naked long strategy)
Cost of the trade = Difference of premium that u pay for buying first leg minus the premium u collect for selling other leg.
Maximum Risk = LIMITED. Cost of trade that is calculated above. (Isn't it less risky then buying naked call where whole of your premium is at risk)
Maximum Reward = LIMITED. Difference of the two strike prices minus the money that u have paid to open this trade i.e. cost of trade. (Naked option buying, theoretically, has Unlimited reward..but in reality
there is nothing called Unlimited. There is a limit to which stock can rise during the life of the option. Similarly it can't go below Zero. That means it has some limit. )
Break-even point - price level of underlying that must be reached for this trade to be profitable for us. Below that price level, we are in loss because we have paid money to market to take this trade.
This level is = strike price of long leg - Cost of trade (for bearish trade) or Strike price of long leg +cost of trade (for bullish trade)
Effect of time decay = Almost Nil.. When Long leg of your strategy is loosing value due to time decay, the Short leg is gaining approximately same advantage of time decay.
(Another advantage over Naked call strategy, where time decay hurts u everyday)
Effect of Volatility = Almost Nil ..During volatile time when u pay more to buy an option, but at the same time when u are selling other options, and collecting more money for same volatility.
Effect of price movement of NIFTY - Any move of NIFTY will have +ive impact on one leg of this position whereas other leg will be -ive impacted. This impact will not be same on both legs depending on
at what level NIFTY is compared to our strike price of 3900/ 4000..

addtion --> You might come across "What is debit/credit spreads ?". Following post has and answer of this question.
http://www.traderji.com/options/305...ng-strategy-option-spreads-35.html#post418640

(I have attempted to give this explanation in simple terms to that people with limited knowledge of options trading. I do not want to bring complexity of option pricing / Greeks like delta, gamma, vega here. But if u find it interesting then please read about it from any standard source /book/ site etc and discuss your doubt /experience here).

Happy Trading
 
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AW10

Well-Known Member
#3
Planning an Option Trade

2) Lets take an example and construct a spread trade.
First we need to have some idea about the market direction (doesn't matter even if we are proven wrong. nobody is 100% right here) - so as per our current analysis, we find that market is going down since budget day. And we believe that it is going to go down further. That means we want to take bearish position. Our analysis also suggest that market can fall to 3800 level. For simplicity, lets use PUT options to trade.

Direction - Bearish
Construction - Buy 1 - PUT option strike 4000, and Sell 1 - PUT option strike 3900
Cost of trade (or net premium)= taking Friday (9/July price for July expiry) = to buy 4000 Put we have to pay 144 and when we sell 3900 Put market gives us 97.
so our net cost 144 - 97 = 47/-
Max Risk = 47
Max Reward = 4000 - 3900 – 47 = 53. (max value of spread = 4000 - 3900 = 100 rs.)
Break-even point = 4000 - 47 = 3953. (that means, if market closes anywhere below 3953, we will be +ive on this trade. If it closes below 3900 we will get max value of 100 pts. If market closes above 4000 then we will loose 47 which is max that we have put in this trade from our pocket)

----------------------
This part is for addressing the most important components of trade planning - EXITs

Stoploss point - Price = When value of spread falls below 25 (i.e. out of initial investment of 47, we are not ready to loose more then 47-25 = 22 rs)
Stoploss point - Time = When 4 days are remaining for expiry and position is still in loss

Profit taking - Direction = When my view about market's direction has changed from bearish to bullish or sideway.
Profit taking - Price = When atleast 80% of potential max profit is achieved. Better to move on to next opportunity rather then waiting for last bit of profit.

EXITs is something that depends from trader to trader hence there is no single correct solution for it. But above points will help you in preparing in advance for eventuality. Once we are in trade, emotions start impacting our decision making capability hence it is better to think about them right now when there is nothing is at stake.

Happy Trading
 
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AW10

Well-Known Member
#4
Monitoring Spread trade -If we are comfortable with risking 47 to make 100 rs. We are not worried about loosing 47 rs then we can very well forget about this trade till expiry.
But most of us may not fall in this category and we want to see what is going to happen from now till expiry.

As market falls, price of Long put will increase, and price of Short put will also increase.
But rate at which our 4000 Put will gain value will be faster then what 3900 Put will loose.
If market goes to say 3950 (currently at 4003), then net premium of this position will be more then what we paid (i.e > 47).
Similarly if it goes to say 4100 level, then we may still be able to close the position and gain less then 47 rs. say 20 rs. and reduce our loss from 47 to 20.

At anytime, to monitor this position we have to take the current net premium that we will receive from market.
i.e. for 4000 option take the current Bid price (price on the left side of price table/order book) and for 3900 option, take the Ask price (i.e. price on right side of price table /ordre book).
If confused, then follow the simple logic -
- We always get the worst price from market (cause we are not FII).
- Take the Lowest price for strike that u want to sell back.
- Take the highest price for strike that u want to buy back.
- Calculate the difference and you will know what is the current worth of your position.

Max reward of 100 will be achieved when market expires on 30-July expiration day below 3900. Similarly Max risk of 47 also comes when market closes above 4000 on expiry day.
We can very well close this position for less then 100 rs of reward.. or less then 47 rs of loss before the expiry at any time.

My strong advice will be to close both legs at the same time.. (you might be tempted to close only the loosing leg and but that action will increase the risk of reaming open leg.
If you share my belief then as a trader we should be looking at reducing risk, not increasing it).

Happy Trading
 
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AW10

Well-Known Member
#5
Collection of some good posts on FAQs

1) Link to a post addressing the points about selection of right strike price for spreads trade -

http://www.traderji.com/options/31874-linkons-breakout-system.html#post348923

This thread also has good amount of info about developing a trading system using Spreads.

2) Link to a post highlighting the differences between Debit spread and Credit spread

http://www.traderji.com/options/305...ng-strategy-option-spreads-17.html#post377167

3) How to understand the option chain table data on NSE site

http://www.traderji.com/options/30...ng-strategy-option-spreads-25.html#post410011

4) Understanding Open Interest (OI)
My views..
http://www.traderji.com/options/305...ng-strategy-option-spreads-49.html#post440767

Example -
http://www.traderji.com/options/305...ng-strategy-option-spreads-45.html#post433863

5) Post comparing Short Straddle v/s Short Strangle and what factors to consider in selecting them

http://www.traderji.com/options/305...ng-strategy-option-spreads-47.html#post436832

Happy Trading
 
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AW10

Well-Known Member
#6
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AW10

Well-Known Member
#7
Where to Start in Options Trading

This post is not related to SPREADs but it is my thoughts about learning that one needs to start properly in OPTIONS TRADING. It was in reply to following question --

I want to learn options trading. Do we have to be well versed with the equity trading. To be frank I have a year and half exp in swing trading that too not a active participant.

AW10,Lazytrader, Kindly inform me the ways to learn options from beginning that too very basics. Have gone through the websites provided earlier and was able to grasp some of the stuffs. However, will appreciate if explained in detail step to step to gain the knowledge of options trading.
tvrssvk , I will attempt to give u very practical answer to start in options trading.

1) To make money in any trading (be it a house, stock, goods, options or anything), very first thing to know is the direction of the market. Can u make money by buying something, when market is falling. So very first thing you need to learn is to identify the current trend of the market (up, down or sideway). Better u are in this, solid is your foundation. E.g. – If you are in Nagpur and want to go to Delhi, then first thing u have to do is to be on platform where Northbound trains are arriving, and then u need to board the right train for your destination. No great deal but just common sense.. But u will surprised to see how often it is not followed in market where people buy, when market is going south.

2) Once u know the direction of market or stock that u want to trade, then choose appropriate option strategy for this.

3) There 6 basic risk graphs in core option and stock strategy. All other strategy is just combination of these 6 basics. They are – Buy Stock, Sell stock, Buy Call, Sell Call, Buy Put, Sell Put. Spend as much time as required to understand them on parameters I am going to mention in next point.

4) For any strategy (including the 6 basic one), know how they are constructed, what is max risk, what is max reward, where is BREAK-EVEN point, How the risk graph looks like at expiry, suitable market condition favourable for these strategies. Once, you should be able to draw risk graph without any option analysis tool, then u pass out from this stage.

5) Understand the concept of option pricing, intrinsic value and time value, the factors that affect option premium. Focus on not the theory, but how change in those factors will affect the premium. Watch them in real life, experiment with them using option calculator.

6) At advance stage, u can look at transition of risk graph from now to final stage at expiry, various option Greeks etc., various strategies that are combination of 6 core strategies. This is the stage, I will advise one to start using a tool. IMO, A professional’s doesn’t become handicap without a tool. He/she know how to work without tools.. And if they are given the tools, then their performance and efficiency zooms. They know what they are doing, or what they want to do because they have solid foundation. IMO, a great tool in the hand of a monkey is no different from a banana or a stone in its hand. Cause monkey doesn’t know how to get best from it. But give a great tool a professional, and see the difference.

There are different approach to get above (read books, take mentorship, play in market and learn the hard way, go-to school/collage etc). The decision is yours. But be careful about selecting the place or option that u are going for. If u read wrong book, go to wrong person for training, do wrong course, etc, you will be just wasting your resources (time, money, energy etc.).

This is just to give base in option trading, so that u can plan an option trader properly. Remember, that doesn’t make you a trader still. Trading involves Money mgmt, psychology, risk mgmt, system testing etc which is beyond the scope of this post.

Last but not the least, there is not defined path that u need to follow to get started in options trading like first stocks, then futures, then options. If it is done appropriately, then you can start directly in options, without getting into stocks etc. If you know stock trading (better have good track record in stock trading), then few initial steps are not required.
But that is not limitation, even if you have never traded stocks. As long as you learn to read market trend, you can start with options trading.

LEARNING MATERIAL

There are many good resources available on internet to learn about Options. Some of them are:-
1) CBOE dot COM site // Learning Center section
2) 888Options dot COM site
3) NSE site // "Home > NCFM > NCFM Modules" section and check out the study material on following modules
- Equity Derivatives: A Beginner's Module
- Derivatives Market (Dealers) Module
- Options Trading Strategies Module
4) INVESTOPEDIA dot COM


Happy Trading
 
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AW10

Well-Known Member
#9
ST, that was not my intention to increase your reading load on weekend. Enjoy that time with family and friends. Looking forward for your posts carrying practical option trading experience.

Have great weekend
 
#10
It's a great thread for a beginner like me.
If I have understood you correctly, in the stated example one can only make a profit Rs 100 (which is maximum possible) after expiry, if NIFTY closes below 3900 at the time of expiry.
I suppose the fluctuation in prices of the Puts are such that the net premium will never exceed Rs. 100 in the intervening time before expiry.
To get a better idea I want to ask you a question about two situations.
a) I buy this Bear Put Spread with 20 days left to expiry and on the very next day NIFTY crashes to 3900. What kind of return can I expect by closing this Spread rightaway?

b)Another situation: The Nifty falls to 3900 with 10 days left to expiry. If I close the position then would I get a better or worse return on my investment of Rs 47 compared to situation a) ?

Thank you.
 
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