iCharts Discussions

[SwingTrader]

Options Spreads

I will start posting in installments some educational stuff about options based on how I trade. This may or may not be in line with what is given in various books. Questions/criticism are welcome. Basic knowledge of options trading terminology will be useful. I can't post something simpler than this as it would get quite long. So please read up about options first if you are new to options.

NOTE: These are my views only. These are not the only way to trade options. Consider them as educational ideas only. Experiment by paper trading etc before using any of this info.

Terminology Used:

Long Option : A trade where one buys a call or put.

Vertical Spread : A trade where one buys an option and sells another. Example: BUY NF 6000 CALL + SELL NF 6200 CALL. This is a bullish call spread.

Diagonal Spread : A trade where one buys a far month option and sell a near month option. Example : BUY NF JAN 2014 6200 PUT + SELL NF DEC 2013 6000 PUT. This is a bearish diagonal put spread.

Most of the time I trade either vertical or diagonal spreads. I use verticals when there is not much time left for near month options to expire. Majority of the time (when there is 2.5-3 weeks or more left for near month expiry) I trade diagonal spreads.

I will explain below why I use diagonals most of the time. I will start with long option, then go to vertical spread and then to diagonal spread to explain the differences and pros/cons. The reason for trading diagonals is risk management. If you look at the price of options, it would look like an out-of-the-money (OTM) option is the cheapest. But the issue with these options is that there is only time value in its price and that can vanish very quickly either with time or by a price move against it. Trading a small OTM options position is fine but deploying decent amount of funds in such options is extremely risky and such positions are extremely difficult to adjust when required. In short, OTM options are very low probability trades. In-the-money (ITM) option could be used but the funds required would be significantly more. Below is an example of a trade. Let us see how it would fare when various options strategies were used.

I will use a failed trade as an example because risk management is my primary focus, profits are secondary consideration. I initiated a bearish trade on 30th Sep based on NF OTM PCR rank signal followed by price breaking support. On 9th Oct I exited the trade as the signal was negated.

I will be using EOD prices to keep things simple. This will be close approximation as I usually initiate trades between 3:00 and 3:15 PM only.

1. Long option (BUY NF OCT13 5900 PUT @ 222.10)

On 30th Sep NF closed at 5791.45. This is an ITM option. Here is what happend:



I would have lost 60% of the amount. An OTM option would have lost more percentage wise. I am concerned about the money lost percentage wise as that is what I will have to look at when deploying large position size.

I had actually used a long option to trade this signal. This was for simplicity as I was just testing. But I would not even think about this when trading a large position.

2. Vertical Spread (BUY NF OCT13 5900 PUT + NF OCT13 SELL 5700 PUT)

In this case we are using the same 5900 PUT used earlier but we are also short 5700 PUT which will act as a sort of hedge but will also limit profits. The max profit in this case will be difference in option strikes (5900 and 5700) minus the trade debit (amount used to buy the spread - 5900 put cost minus 5700 put cost). I am fine with limited profit as we are talking only about a month's time when trading options anyway. Here is how this position fared:



Much better, especially for people like me who are wrong most of the time. You don't lose much if trade goes against you. The percentage loss has been computed on trade cost + full margin required to hold the trade.

3. Diagonal Spread (BUY NF NOV13 5900 PUT + SELL NF OCT13 5700 PUT)

This is my favorite - the diagonal spread. Here we buy the Nov 5900 put and short the Oct 5700 put. Do note that the cost of this trade will be higher due to more premium required for the next month long option. The advantage is the higher positive theta of the short option and lower negative theta of the next month option when compared to vertical spread. Here is how it fares:



One does not lose much in this case. The added advantage with a diagonal is that it will profit lot more than a vertical spread if one is right about the direction. It will profit little even if price does not move or moves a bit against you too.

Every strategy has disadvantages. The disadvantages of diagonal is (other than the limited profit which is actually fine with me) that if NF volatility falls then it will not profit that much. This is because diagonals have higher vega compared to verticals. But I am fine with that, falling volatility only increases the amount of time required to profit. If price does move in our direction the position will be very much in profit.

For all the strategies there are lot more combinations. One can use ITM, ATM, OTM options for longs and this will drastically modify the profit/loss of these strategies. I like to use ITM options for longs as they have lot more intrinsic value in it and lower time value. In other words, they decay less everyday. The combination I have shown above (ITM long + OTM short) is the combo I use all the time for spreads.

I have highlighted a failed trade first because we need to take care of the risk first. Profits follow automatically if risk is handled well.

In the next installment we will look at a winning trade so we can compare the profits of these strategies.

[sairanga19]

st sir excellent , please tell us are this trades should continued still expiry or should be exited at the middle if nifty changes trend

[pearl58]

Eccellent Sir, Very informative, written in such a simple way. Really very helping, thanxz a lot,

[paa]

Thank you ST sir for this thread.
I was exactly looking for this kind of stuff.
Please let us know how to manage this strategy in the middle if this turns out a loosing one.

[SwingTrader]

Sai, Pearl, Paa,

Thanks.

I am preparing the content to post, I will post as it gets ready. Here is the agenda:

1. Long option vs Vertical spread vs Diagonal spread (Losing trades) - DONE
2. Long option vs Vertical vs Diagonal (Profitable trades)
3. Long option vs Vertical vs Diagonal (Going nowhere trades)
4. Effect of volatility trend on each type of trade with focus on diagonals
5. Diagonals - In depth (Pricing, when to initiate, dos & don'ts etc)
6. Diagonals - Trade Management (Stop loss, Profit targets, Trade adjustments)

Stay tuned...

[adsingh101]

Thanks ST Sir for such an informative thread.

[paa]

Wow! Gr8! ST Sir, I am desperate to learn this.
Thanks in advance.

Regards

[reemajainiaf]

Hello ST,
There are so many questions on my mind which I am not able to put in words because of my lack of knowledge. Somewhere, you mentioned you can convert a losing position in to a profitable one. How do you do that? Thanks again for this thread.

[SwingTrader]

[reemajainiaf]

[SwingTrader]

2. Long Option vs Vertical Spread vs Diagonal Spread (Profitable Trades)

In installment #1 we saw losing trades, this time let us see how these strategies perform when we are right about the trade.

One important point : Even though the focus of these lessons are diagonal spreads, one should look at all strategies openly. The idea is to pick the right strategy for the right setup. Long option is quite risky as there is no downside protection/hedge but if one is really confident of the trend and is ready to adjust the trade (to a vertical spread) once it is in profit then it also could be employed. Vertical spreads are extremely versatile and I use these all the time, especially when there is not much time left to expiry (so diagonals can't be used - this is Indian market specific condition). Diagonals are good especially when volatility is low as its profits get amplified if volatility explodes (vertical also will be excellent in such cases).

The profitable example I am taking here is well chosen based on hindsight. But it is also a signal I had taken based on NF OTM PCR Rank. On 2nd Aug price broke down below a support and rank had already indicated clear bearish bias few days ago. Volatility exploded and would have benefited all long option trades. Here is how the strategies performed. NF closed on 02.08.2013 at 5705.55.

Long Option (LONG NF AUG13 5700 PUT)



There is no argument about this strategy. If one is right about the trade then long option works like nothing else. But this strategy is tolerable only if one is trading a small position size as the losses or drawdowns can be stomach churning.

Vertical Spread (LONG NF AUG13 5700 PUT + SHORT NF AUG13 5500 PUT)



Here we don't have sky reaching returns like long option but we also don't have the stomach churning moves against us. Any systematic trading plan should consider verticals as one of their core strategy.

Diagonal Spread (LONG NF SEP13 5700 PUT + SHORT NF AUG13 5500 PUT)



Similar to vertical spread. But this strategy will have lower losses if the trade goes against us. And they will benefit more if volatility explodes (due to the larger vega of the trade due to the next month long option). Profit will be slightly more than the vertical spread. This is not too clear here but as we will see in many other examples I will post in the near future, diagonals profit more in general and lose lesser than verticals.

But I concentrate on both because in the Indian market we can initiate a diagonal only in the first week-to-10 days after expiry. I am talking about NF only. Since we have only three active months and out of those only the first two months will have real good volume, for all practical purposes we don't get much time to initiate diagonals. In the US market there is great flexibility in trading diagonals as there are hundreds of liquid scrips and many many months that are liquid enough to trade.

About trade costs and margins - The trade cost + margin for both verticals and diagonals comes to almost the same. For verticals the trade cost is going to be less and margins are higher (than diagonals) and for diagonals the trade cost is higher (than verticals) but margin is lower.

Profits - The way I setup vertical and diagonal, max profits most of the time are around 20%. If volatility explodes then we could see 25-30-40% profits but once profit goes above 20% I am very careful.

Profits can be greatly amplified if one takes out-of-the-money long instead of the ITM long I strongly suggest. But this carries lot more risk as the loss can be high if trade goes against us. ITM long and OTM short is preferable for both verticals and diagonals.

Diagonal strike selection - I will go into this in detail with examples but here is a quick idea. I try and make sure I get a minimum of 30% hedge for my long option when trading a diagonal. Eg. see the above trade, long option is priced 158.05 and short option is priced at 54.85. So short option price is around 34.70% of the long option. This is okay. Anything less than 30% is a problem as it would not provide adequate hedge. More hedge you want the lesser profit you get, less hedge you take the more potential profit. But same goes for losses, more hedge - less losses and less hedge means more potential for loss.

More coming later this weekend....questions are welcome in the meantime.

[udaysahai]

Great thread Sir, keep up the good work.
Thanks and best regards.

[sambhaji_t]

Thanks a lot for sharing such useful information. Simple & effective.

[rrk2006hyd]

Hello ST, thanks for sharing..the knowledge..keep going..

[rk_a2003]

Long option booked loss was 60.20% verses booked profit of 135%.Where as it was -10.87% and +35.22% in case of Vertical spread ; -5.85% and +40.65% in case of Diagonal spread. The risk reward is 1:2 ; 1:3 and 1:6 approximately

That’s why Diagonal spread is superior. Provided this case study is applicable broadly to various nuances of market, with a strategy like Diagonal spread you are bound to be a winner. Even if your directional calls are 70% wrong.

Even you can play a probability game with this which may turn you finally in to a winner.

Usually retail investors carries a mammoth task of precise timing in trading due to their limited resources and draw down specter. Such strategies remove both the burdens single handedly and free them. In this case they need not crave for precision in timing the market.

Thanks ST for delivering such a gem for all of us.

But still this strategy demands a fairly good directional call, some precise planning and proper choosing of spreads with entry and exit at right point of time.There is no free lunch anywhere in the world. Of course, ST provided us partly free lunch…I guess.