Option Investor
Educational Article

Strategy Selection: Spreads - Planning For Profit..

HAVING TROUBLE PRINTING?
Printer friendly version

By Ray Cummins

The key to success in any form of trading is to have a well-defined strategy, a plan of attack. The options market offers a variety of different ways to profit but the risk can often be significant. The easiest way to limit or control the potential for loss is to devise and follow a specific system or set of rules. The structure of this system will require a number of profitable strategies along with the knowledge to implement and manage them correctly.

The primary requirement for profitable trading is the ability to achieve reasonable returns and control risk. A plan without specific targets and loss-limiting features is certain to fail in the long-run. A careful and deliberate approach to strategy selection is the first step in the process. After the principal techniques have been identified, it is imperative to execute them with precision and discipline. Discipline in option trading is the ability to maintain "self-control" and execute the plan. The most difficult skill that traders must learn for is the ability to overcome emotional impulses. When real money is at stake, the influences of greed and fear (of loss) will attempt to sway your judgment, hindering a rational thought process. If you can not overcome these effects, the chances of success are slim. That is the reason it is so important to utilize strategies that promote disciplined trading. Techniques that offer little opportunity for indecision generally provide more consistent returns and far less risk than those with a high level of maintenance.

Successful trading strategies have a number of common traits; ease of execution, flexibility and well-defined principles, but the most important characteristic for the majority of investors is asset preservation. In the options market, the most profitable systems are those which employ sound defensive measures. The ability to protect and conserve portfolio capital, while achieving consistent returns is a fundamental quality of any technique. Fortunately, there are numerous option trading strategies that satisfy this criteria and our goal at the OIN is to help new investors discover the most appropriate combination of trading techniques and provide them with the tools necessary to profit on a regular basis. With that concept in mind, we continue our introduction to fundamental spread strategies.

The majority of option traders use derivatives to speculate on the movement of stocks and indexes. The appealing feature of option ownership is leverage with limited risk. If a trader correctly predicts the market direction and takes the appropriate position, he can expect to make a profit. Unfortunately, that technique has a low probability of success. As you know, even when the market moves in the predicted direction, owning the correct position (CALL or PUT) will not necessarily be profitable. The reason is, over short periods of time (while the trader is waiting for the option to rise in value), the position is at risk from a variety of changes in the market. One method that experienced traders use to overcome that problem is spreading. Spread trading is simply a way to take advantage of mis-priced options, while at the same time reducing the effects of short-term changes in market conditions so that a position can be held to maturity.

The majority of successful option traders engage in some form of combination, position or spread trading. The basic technique involves buying and selling simultaneous but opposing positions in different option series. The most common strategies are used to reduce the cost (and the risk) of a position while providing a higher probability of a limited return. Advanced methods of spreading rely strictly on pricing disparities. Experienced traders know there is an identifiable relationship between various series of options and when the relationship appears to be mis-priced, they will buy the under-priced position and sell the over-priced position. The spread will profit as the prices of the instruments return to a linear relationship.

The wonderful thing about option trading is its diversity. There are an incredible number of strategies available, one for every type of market trend, character and outlook. Positions involving combinations of calls and puts, with different strike prices and expiration months, along with index and futures options, offer the astute trader a variety of ways to participate in the market. This assortment provides even the most conservative investor the ability to construct positions with an acceptable level of risk versus reward in almost any situation. In addition, students of option pricing theory can identify combinations with potentially superior returns when the relationships between the options are theoretically skewed.

While there is no perfect position, successful traders learn to maximize profits and hedge their risk in as many different ways as possible, limiting the effects of short-term volatility and market gyrations. Obviously there is no way to completely eliminate risk but you can reduce it much more than that of a inexperienced trader who does not utilize all of the available strategies.

Next week's Topic: Strategy Basics - Diagonal Spreads..

Ray Cummins
Spreads Editor

Options 101 Archives