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.

[rk_a2003]

Dear ST,

I have not yet read your post but, before that I would like to say... Thank you very much.

[reemajainiaf]

Thankyou ST
Waiting for more though it will take some time to understand what you wrote. Thanks again.

[rk_a2003]

It's an excellent post from practical point of view. You have boiled down your experience in to this post and handing over us, otherwise it might have consumed years of struggle to get this knowledge. Whole heartedly I Thank you again.

I would like to see how a Diagonal Spread fare in case our directional call is right (with high volatility and also with low volatility).

In my opinion it's a good thinking to buy ITM option and sell OTM option (which will have more time premium compared to ITM option.).That's the reason for reduced losses in hedged position when directional call goes wrong.

I experimented with buying and selling calls and puts in individual stocks but not in NIFTY that too I never tried ITM Calls/Puts.

I would like to add one more point... You need a lot of patience to trade this type of spreads and should know to close them at right point of time.

"....for people like me who are wrong most of the time. You don't lose much if trade goes against you..."

ST, you must be kidding, I don't believe you.

[SwingTrader]

rk, reemajainiaf,

Thank you.

rk,

I would like to see how a Diagonal Spread fare in case our directional call is right (with high volatility and also with low volatility).

Yes, we will see the effect of volatility increase/decrease on both profit & loss. I will post examples in coming installments.

I would like to add one more point... You need a lot of patience to trade this type of spreads and should know to close them at right point of time.

Yes, there are few points to keep in mind when trading diagonals. I will discuss all those. You are right about position exit, it is important especially in the last week of expiry. I will go over these and more points in the coming installments.

ST, you must be kidding, I don't believe you.

OK, I exaggerated that a bit

[vinay28]

".....especially for people like me who are wrong most of the time....."

that's violation of my copyright!

on a serious note, ST, how/when do you square off the two options? both together or???? Also, in case of diagonal spread, one has to cover ITM at least just before expiry since tax on automatic expiry is huge. In such a case what do you do?

[SwingTrader]

[SwingTrader]

Everybody,

I will be moving this topic to "SwingTrader's Corner" forum section under "Technical Views by Team iCharts" section. I will also create a separate topic there for options spreads. Best to keep market sentiment & options spreads separate for clarity.

I will move this topic tomorrow.

[SwingTrader]

Updated NF OTM PCR Rank chart (27.11.2013)

Rank is at 75.60%, so bearish bias continues.

I have closed my bear put spread. I had a LONG NOV 6200 PUT + SHORT NOV 6000 PUT position on. 6000 PUT has lost most of its value and would not be a good hedge to the 6200 PUT, so it was best to close it given tomorrow's expiry day and probable volatility it might bring. The profit on it was only around 5% (on trade cost + margin). I will initiate a diagonal tomorrow. Last time I did not initiate a diagonal as it was too late. I like to have atleast 3 weeks left to expiry when I initiate the diagonal. I had initiated the trade on 12th Nov and there was not much time left. If less than 3 weeks are left, we would not get a good price for the diagonal. I mean, we need the short option to provide a good hedge to the long option. Ideally I like the short option to have atleast 50% the premium of long option. This is not a tight rule but 35-50% is good. This also the reason why we should have atleast 3 weeks to expiry to get good price (more time value). More on this in detail later in options spreads' next installment.

[vinay28]

if the market was indeed bearish as many experts are talking over all the digital media, rank should have crossed 80/90% by today if not earlier. That's why I am still not convinced about overall bearishness. But in any case, at least we now have rank as another confirmation. Only dicey part is change in rank due to shift to next month near expiry as apka had pointed out.

[SwingTrader]

[vinay28]

[SwingTrader]

Updated NF OTM PCR chart (28.11.2013)

Rank at 56.60%. Still hovering above 50%, bearish bias. It is strange that it is unable to breach 80%. It usually hits 80% before the down move begins and this time even after NF has moved down from its highs the rank is yet to hit 80%. I am hoping we should get some clear indication after tomorrow's trading.

[vinay28]

[SwingTrader]