Most traders don’t understand spread trading.  They think that placing a bullish instrument simultaneous to placing a bearish instrument is at cross purposes to each other.  Why not go long if bullish and short if bearish and forget paying the extra commissions.

There is a method to our madness when spread trading.  It has to do with 1) Limiting Risk and 2) Reducing Volatility.  Let’s say that we agree that the market is heading higher and my friend “Directional Dave” buys a Long Call to optimize the trend.  However, there are a million other traders that are thinking and doing the same thing.  As a result, supply and demand does its thing and as demand increases for that Long Call, the price is pumped up (volatility).  Our friend “Directional Dave” is now paying a premium for that call.  As a holder of an option, one must be concerned about time decay and implied volatility.  Dave’s Long Call is a wasting asset and as each day passes the option is losing value and is also susceptible to changes in implied volatility.

The bottom line is that our friend Dave is the owner of an asset that can easily devalue even if he gets the direction right.  Enter “Sammy Spreadtrader”.  Sammy also feels that the market is rising, but he also realizes the pot holes in the road to riches and decides to “spread off” some of the risk of the Long Call.  Sammy sells a call one strike price higher than the Long Call and takes advantage of the increased demand and volatility of the pumped up options and collects premium to offset the cost of the Long Call.  The result is a position that reduces the risk of the trade and still allows for a very attractive potential return.

“Directional Dave” now sees an opportunity to sell premium.  He is beginning the see the light.  Dave assesses the market and determines that the underlying stock is neutral to bullish.  Not the absolute best scenario for a Long Call because he needs movement to consider a long option.  Dave realizes that money can be made by selling a Naked Put.  Good job Dave, you’re getting the hang of it.

Sammy steps in and also recognizes the opportunity but takes a much more prudent approach and buys a Put beneath the Short Put in order to limit the downside risk.

So you see, it doesn’t take that much more to become a spread trader.  That additional option instrument can make the difference between blowing up your account and being consistently profitable.  To the outside observer, spread trading does seem a bit incongruous.  However, those of us who know the craft are putting money in our pockets and doing it without stress.  Best, Robin

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