Options Spreads Reduce Cost, Define Risk/Reward

Back in July 2008, I first noted that institutions were pulling back on options trading volume. Recently, Bloomberg has picked up on the story because the reduced supply has led to higher hedging costs – a simple application of Econ 101. The combo of less capital available to make markets in options and higher volatility from an ugly macro picture has, in turn, made options more valuable than ever before. So is this the best of times for options traders, or the worst? Forex education depends on your willingness to be flexible with trading style.

Higher volatility, for example, leads to much wider zones of profits from a short straddle, as well as from selling naked options. But since we have been steadily beating the drum of using options not only for profit, but to effectively manage market risk, there is another strategy we have not touched on worth covering that relates to all this.

The argument against selling options naked, or being short a straddle, is that the losses will be very large if a significant move in the underlying takes place. While most people (at least, those in charge of risk management on Wall Street trading desks) seem to view market returns as normally distributed, they are in fact leptokurtotic – close to the mean more often than one would expect, but also with much bigger and frequently occurring “fat tails.” The intermediate moves get squeezed, and the overall distribution can be difficult to visualize; Part I and Part II of the “Fat Tails and Options Selling” series will help.

Buying a put or call means one is long “vega” – the measure of volatility and how it impacts option prices. The natural flip side is that being short an option means one is short vega. With volatility high, single long positions can be comparatively expensive, and the easiest way to reduce the net cost of an options position is to create a spread. There are four types of spreads.

Let’s assume we have a moderately bearish outlook on the S&P 500, and want to buy puts. Below is a chart of the S&P’s recent performance.

An outright put position might not be ideal – the March $84 SPY Put (SCZOF) trades for $4.85 as of the most recent market close. Buying that put and then selling a put with a lower strike price – say, the March $80 SPY Put (SZCOB) for $3.15 – gives a net debit to the trade of just $170. This is the maximum loss, and although it lowers the upside potential if SPY breaks below $80, the reward here ($230/spread trade) could be seen as outweighing the risk. Below is a payoff diagram for this sample trade.

Options spreads are an advanced strategy, but one that can be used to make defined bets at a reasonable cost. Traders frustrated by high options costs, or looking to expand the number of profit opportunities available to them, should become familiar with spreads.