Why Spread Options

By JMTG’s Head Analyst James Mound

            I am often asked why I am such a big believer in spreading options.  Simply put, option spreading provides avenues to create definition to trades that futures or single option trades do not.  Allow me to explain.

            When you buy or sell a futures contract you are making a simple judgment of market movement: will the market go up or will it go down?  Your exit strategy then determines the risk to reward ratio of the trade as well probability.  When you buy a put or call as a one option trade you are forced to make the same judgment of market direction, but are defined by limited risk and time as well as reduced probability.  However, when you spread options with or against each other you can more easily define the risk, reward and probability scenarios of a trade and, in turn, open yourself to a world of choices.

            If you were lost in the wilderness and could have either just a knife or a complete survival kit with a machete, matches, a compass, water purifier, etc., which would you choose?  You would clearly want the survival kit.  Yet when traders restrict the trading strategies they apply to only utilizing futures they are essentially ditching the survival kit for the knife.  Option spreading allows a more complete trader to have a full arsenal of weapons to attack the market.  Let’s look at a case in point.

            On the 13^th of August the FOMC meets to discuss interest policy, with the market expecting a cut in rates.  Technically, the 30yr bond has been extremely volatile during a technical breakout to the upside.  The market sits poised to react ferociously to the announcement after the meeting.  But you are no swami.  In fact, you don’t have the slightest clue what the Fed is going to do, much less the real market reaction.  And yet you recognize clear indicators of explosive volatility the day of the report and the days and weeks following.  If all you could play is a futures contract you would have very limited trading choices.  You could have stops on either side of your perceived support or resistance, thus stopping you into the trade after a predicted breakout occurs.  Unfortunately, that strategy offers up a lot of potential problems.  The market could easily reverse its reaction after getting stopped into the trade, causing you to get stopped right back out of the trade.  The market may have any number of other events occur that cause the trade to go against you.  You might have even missed a big part of the move just waiting to get stopped into the trade in the first place. 

Instead, you could buy a call or a put, which forces you to pick market direction (which you have already admitted you can’t predict) but with limited risk and big potential profits.  You could even argue that buying options in general, going into a period of increased market volatility, generally offers the highest probability of success.  Nevertheless, this strategy misses the focus of the results of your analysis of the market.  All you want to do is profit from the price volatility and avoid having to pick a direction.  There are two basic strategies for this type of scenario that produce the DEFINITION you need in your trade design.

            A straddle is an option spread that involves buying a put AND a call with identical strike prices as close to the current market price as possible.  This allows you to profit on a selloff with your put, or a rally with your call.  Let’s say the September 30 year T-Bond is trading at 108-00 when you place the trade just prior to the report.  You would purchase a 108 call and a 108 put for September (expires August 23^rd).  For discussion’s sake let’s say you paid 32/64ths ($500) for the put and another $500 for the call.  Then, by the trade’s definition you are expecting the price volatility after the announcement to exceed $1,000.  This could mean either holding both options until one side exceeded the necessary price movement to hit your profit target, or timing the exit of both options at different times to maximum the best possible return on each of them.  This difference in strategies is determined by your forecast of the volatility being either in the form of a breakout and trend in one direction or a more choppy and back and forth volatility.  This trade design confines the risk and reward of the trade to what you are truly confident in predicting.  This is definition that adds a great weapon to your trading aresenal.

            A strangle is similar to a straddle, but differs in that you purchase a put and a call equidistant to the price of the market.  Using the same example as above, an example of a strangle would be to buy a 109 call and a 107 put.  This changes the trade design because the cost will be significantly less than a straddle, which could potentially offer a higher Return On Investment (ROI).  However, the necessary volatility becomes higher due to the greater distance the market price has to travel to exceed the strike prices. 

******Both the strangle and the straddle trades are featured in www.moundreport.com ‘s Trade of the Month for August.

*Disclaimer: There is risk of loss in all commodities trading. Please consult a James Mound Trading Group Broker before you trade for the first time. Losses can exceed your account size and/or margin requirements. Commodities trading can be extremely risky and is not for everyone. Some option strategies have unlimited risk. Educate yourself on the risks and rewards of such investing prior to trading. James Mound Trading Group, or anyone associated with JMTG or moundreport.com, do not guarantee profits or pre-determined loss points, and are not held monetarily responsible for the trading losses of others (clients or otherwise). Past results are by no means indicative of potential future returns. Information provided is compiled by sources believed to be reliable. JMTG or its principals assume no responsibility for any errors or omissions as the information may not be complete or events may have been cancelled or rescheduled. Any copy, reprint, broadcast or distribution of this report of any kind is prohibited without the express written consent of James Mound Trading Group LLC. Total cost, or cost/credit of trade (as referred to in the trade above), includes the cost/credit of entry, commissions and fees. Typical commission is an approximate mean of commission rates amongst JMTG customers, but can be more or less depending upon the individual account/customer, services rendered, account size, trading volume, etc. Options do not necessarily move in lock step with the underlying futures movement. Commissions at JMTG range from $3 to $27.50 per side depending upon the market traded and specific commission rate charged to the client. Fees range from $2.88 to $7.50 per side depending upon the market traded.