A trader wishing to sell options like a professional may want to consider spreading as an alternative strategy. But beware: of all the hundreds of different option-spreading strategies available, there are only a handful that we’ve found to be practical for individual investors.
Some brokers and authors in the industry are not going to like what they read here. We are not going to say outright that something doesn’t work or that a particular strategy does not have its merits. Given the right market situation, almost any strategy will work some of the time. Our intention is to share the observations we have made in trading futures options with no disrespect meant to the knowledgeable authors in the field of option spreads.
The problem with trying to learn 101 different option spread strategies is that one first must learn each detailed strategy and its benefits, drawbacks, profit potential and risk. As if this is not difficult enough, the investor then must learn in what situations to use each strategy. It’s not enough for the market to move up or down.
“The reverse triple screaming phoenix spread works best in a market that begins to move higher, then moves slightly lower, drifts sideways for two to three weeks, makes a left at the Wendy’s on the corner, and then soars into expiration, making new life-of-contract highs the day the option closes out. In this situation, the user would net $2,500 per spread. The perfect spread for a market in this situation — but only if the Vega turns net positive before the Theta becomes neutral.”
This is a fictitious example, of course. But it demonstrates our frustration with the public’s seemingly insatiable appetite to “learn” complex spread strategies that they could rarely hope to use effectively.
Many traders new to options believe it is necessary to learn all these spread combinations before they can trade effectively. This is not the case. If you are looking at inverted butterfly spreads and trying to determine the proper delta balance for your triple-ratio backspread, you’d better be a professional trader who wakes up to a quote screen that looks like a Greek alphabet — or at least a serious trader with a lot of time to dedicate and a lot of money to lose in the “educational” phase of trading. Traders who use these approaches effectively generally have made trading their life and paid their dues through many years of losses. Our experience has been that transaction costs alone make many of these approaches impractical for the average individual investor.
The good news: knowing 101 different option spreads does not make you a good trader. In fact, it may be detrimental to your bottom line. In our experience, effective trading means knowing a few good strategies and executing them extremely well, over and over. Leave the 101 strategies to the intellectual option “theorists.” You don’t have to be on the Pro Bass tour to go out and have a good day of fishing. Nevertheless, there are a few things you should know about spreading before you toss your line in the water.
Futures and options trading involves substantial risk of loss and is not suitable for all investors. OptionSpreaders.com’s Standard Portfolio uses fully covered credit spreads, meaning every short option is paired with a long option that limits the contractual risk of the spread. However, limiting the amount of potential loss does not limit the likelihood of loss or mean the potential loss is small. A spread can lose the full amount at risk, accounts may be subject to margin calls, and commissions and fees will affect results. Only risk capital should be used.
Many firms that hire and train brand-new brokers want them to start out recommending buying straight options or covered spread positions. In this way, when clients lose money (which they often do using this type of approach over time), they lose it “safely,” with no risk of debit liability to the firm. This is one reason it is important to know the broker or trader with whom you are working and his experience in futures and option trading.
The second, equally important reason: covered spreads can generate a boatload of commissions. Situations that often can be played effectively with a futures contract or a single call or put also can be played with an option spread. They are pitched to the client as a way to limit risk and increase leverage, which very well may be true. The fact that the spread may have little chance of profiting — especially after hefty commissions are deducted — is often downplayed.
Instead of buying a single option, a broker may suggest a multiple-option spread containing three to six options or more. Instead of paying one or two commissions, the client pays three to six commissions per spread. For a full-service brokerage charging $100 per round turn per option, this can run into substantial fees — and it can be expensive even with a discount broker charging $30 per round turn. The fact that the “net” out-of-pocket cost per spread may be less than an outright position is often beside the point: commission costs versus potential profit can make the spread impractical for the trader.
To counter the hefty commission charge, some brokers may tout a large potential profit on the trade. A $500 commission for a single spread may not sound so bad if the potential profit is $5,000. But look closely. In many cases it will take an enormous move in the futures price, or require prices to end up in an extremely narrow range, to obtain that potential profit. It’s a low-odds bet — and often the only one who reliably gets paid is the broker.
To be clear, this is not to suggest that every broker is a money-hungry con artist. Quite the contrary — most brokers are good people who do not take advantage of their clients. Nor does a spread recommendation mean your broker is trying to con you. In many cases a long option spread can be a viable, legitimate strategy for a particular situation, and the right option spread can bring its user real benefits. But if you use a multiple-option spread, you want to make sure that if every option in that spread expires worthless, you are still making money. One question we suggest asking before putting on a spread: “What are the odds this thing shows me a profit? How many things can go wrong and we’re still making money?” We look for the highest odds, not necessarily the highest “potential” profit.
1
Potential for profit is hugely different from potential profit. A big selling point of some spreads is their potential profit. Consider the following hypothetical sales conversation.
Broker: John, if the price of heating oil increases by 30% in the next 30 days, this spread will make $3,500!
Trader John: What does it cost to get in?
Broker: A mere $300, John! That’s over a 1,100% return if you’re right — excluding transaction costs, of course.
Trader John: What is my risk?
Broker: That’s the best part! Your risk is limited to the $300 you put in — excluding transaction costs, of course.
Trader John: That sounds pretty good. I sure can’t afford to lose much more. But it sounds pretty safe.
Broker: So how many do you want?
The pitch quotes the potential profit. It never mentions the probability of a 30% move in 30 days — which is the number that matters.
2
Many traders — especially new traders — become enamored of the concept of buying options and the limited risk. Being able to participate in these alluring markets while absolutely limiting risk is very appealing. Buying calls or puts sounds awfully good to them. But it is most often their downfall. In our opinion, to get the most out of these markets, you have to be willing to forgo this type of automatic, low odds, limited risk in favor of responsibly managed risk and higher odds — including strategies where the risk, while managed, can be substantial.
Protecting your investment capital is of utmost importance — but if you are afraid of what will happen if you lose it, you shouldn’t be trading. Many consistently successful traders profiled in Jack Schwager’s investment classic Market Wizards don’t think of trading in terms of the money; they think of it as playing a game well, with money as the by-product. That mindset keeps them unemotional, objective and patient. If safety is what you seek, a certificate of deposit may be more appropriate. If you are afraid to lose, you shouldn’t be trading futures or options. But if you can give up the need for hitting home runs and instead focus on managing your risk, you will have already placed yourself above most small-speculator traders in the market in our opinion.
Fear versus respect. None of this means a trader should approach the market like a Wild West cowboy with guns ablaze. A healthy respect for the market is essential. A great firefighter may not fear the fire he is fighting, but he certainly respects it. Our point is that if you fear the market so much that the high price you pay for that luxury will most likely work against you in the long run. The industry caters to the greed and fear of small speculators — which is why buying options and long option spreads is so popular with this group, and why we tend to advise against positioning in spreads that leave the trader net long options.
The next several strategies are some of the most popular net-long option spreads we have seen pitched by brokers or ivory-tower option books. Any of them can work in the right situation; these are observations, not absolutes. They are featured here so you can weigh the drawbacks — learned from real-life experience — before someone pitches them to you.
A
The bull call spread (or bear put spread) is a broker favorite because it limits risk and increases leverage for the investor — and provides a double commission for what otherwise often could have been achieved, possibly more effectively, simply by buying a call. It is a net long option spread, which means it is for option buyers, and we would generally not recommend it on those grounds alone. We cover it here because of its popularity among novice traders and brokers alike. It is pitched as a way to reduce the cost of buying an option, therefore enabling a trader to take more positions. Imagine that.
How they get your money: bull call spreads sound good on paper, but we have rarely seen them work in practical application. In our experience, if you absolutely must buy an option, your odds are often better on a straight-up long put or call. Unless the market moves beyond the higher strike and remains there through expiration, both options generally will expire worthless, resulting in a loss for the spread holder.
Illustration only — excludes commissions & fees.
Trader Judy is bullish on crude oil at $100 per barrel. In July, she buys a December $130 call for $800 and simultaneously sells a December $135 call for $300. The sale of the $135 call partially offsets the purchase, cutting her out-of-pocket investment from $800 to $500. Because losses on the short $135 call are “covered” by the long $130 call, her contractual risk is limited to the $500* she puts up, before transaction costs.
For Judy to reap the full profit potential, crude oil must be above $135 at expiration. On paper, the trade looks great: low initial investment, large potential profit, limited risk. It sounds too good to be true — and it makes a great sales pitch to novice traders.
*Transaction costs vary by broker. Assuming a Platinum Account, commissions and exchange fees of approximately $36 per option contract would equal $72. Therefore, Judy's cost would be $572 with $4,428 of potential profit.
The flip side. Although the potential profit appears attractive, what is the potential for profit? For the maximum return, crude oil prices would have to rally 35% prior to option expiration. It is certainly possible for a market to make this kind of move. But is it likely? Whenever you hear the terms “large potential profit” and “limited risk” together, your “I will probably lose my money” antennae should go up.
The problem in predicting big moves is that the market is trading at its perceived value every single day. You have to see something coming that the rest of the market does not, predict almost exactly where the market will go, and then have it make a substantial move in your favor in a very short period of time. What is the potential for profit? In our view, probably very low.
Worse, in a bull call spread the two options often have very similar deltas — their values tend to move at nearly the same rate. What you gain on your long $130 call, you often lose almost as much of on your short $135 call. Even if you were right and the market moved up $10, $20 or $30 per barrel, chances are you could not cash out early with much of a profit, especially after commissions. Generally, the long option has to go in the money and remain there through expiration for the buyer of a bull call spread to reasonably profit — and the percentages on that are knowable in advance. A bear put spread works the same way on the other side of the market.
As a young broker, our analyst’s team would put countless hours of research into a market, come up with a reasonable synopsis that often proved correct — and then position clients using a spread of this nature, believing they were protecting clients by offering low investment and limited risk. The market would move higher, just as forecast. The investor would call in: “You guys were right. That market did just what you said! How much did we make?”
“Well, John — we haven’t made anything yet.”
The market had moved higher, but neither strike had been attained. The gains on the closer-to-the-money long option were almost offset by losses on the more distant short option; with transaction fees figured in, the position was still at a loss. Most of the time, broker and client alike would then watch disappointedly as the market topped out or drifted sideways while the spread slowly deteriorated and died on the vine. In hindsight: little chance to profit from what was, at the time, decent research.
B
The butterfly takes its name from the shape of its payoff diagram, with the payoff highest at the middle strike. Although certain strategies can be used effectively by professional and/or floor traders, they can be highly impractical for individual investors — and this is one of them. You have certain advantages as an individual investor. Trying to coordinate the positioning of multiple options at different strikes at desired premiums, while absorbing commissions and slippage, is not one of them. Nonetheless, the butterfly looks great on paper.
Illustration only — excludes commissions & fees.
Trader Mary is neutral on April crude oil: she thinks $100 is a fair price and expects it to be near that level on expiration day. With the market at $100, she enters:
Maximum profit occurs only if the market expires right at the middle strike. The net debit is the maximum contractual risk, before commissions and fees. Illustrative payoff shape; not to scale.
The butterfly and its many variations can be made to sound very good — limited risk with profit potential a multiple of that risk. However, it has two inherent drawbacks:
1
The trader has to pick almost exactly where the market is going and where it will be at a certain time in the future. This is very difficult — and exactly what we stress avoiding.
2
Even a trader who succeeds has to cover four commissions plus fees plus slippage out of profits that are capped by the butterfly. Those costs can cut any profit substantially and make a loss all the more painful.
Other variations include the inverted butterfly, the condor and the cartwheel. Although these can qualify as credit spreads, for an individual investor we would recommend caution with all of them. In fact, be wary of any spread named after an insect, a bird, or anything else you might find in nature.
C
Diagonal spreads are often billed as “free trades.” Have you ever heard it said that nothing in life is free? It is a wise and true statement. Option spreads are like fashion trends — if you missed one the first time, just wait 10 or 20 years and it will come around again. Free trades were popular 10 to 15 years ago, went quiet, and have been resurrected in option newsletters and online advice sites. Like any option spread, for the right trader in the right situation, the free trade has its merits. We simply find it impractical and, in our opinion, a low-odds trade for a serious investor — it is used primarily as a cheap way to buy options.
Illustration only — excludes commissions & fees.
Trader John is bullish on gold. In February, he sells an April Gold 1400 call for $1,000 and uses that $1,000 to buy a June Gold 1480 call for the same price. His objective: have the April call expire worthless, effectively “paying for” his June call, then profit from a rally in his long 1480 call. If it expires worthless too, he “breaks even” — before costs.
Maximum risk occurs with April Gold at 1480 on expiration day and the June call expiring worthless. It sounds great when you first hear it — but then again, so did putting a gas tank in the rear of a Ford Pinto.
Suffice to say, any time you hear the word “free” in investing or trading, run for the hills. The free trade appeals to the crowd with little capital that is looking to buy a lottery ticket on the cheap. They give up an awful lot to get their “free” option. Don’t make their mistake.
This list certainly does not cover all of the option spreads to approach with caution (which, in our view, is most of them). But it gives you an idea of how easy it is to be misled into believing a certain option spread is working to your advantage when, in fact, it is putting you at a disadvantage. Because of the complexity of option spreading, it is easy for option “educators” and self-appointed Internet gurus to lead you into woods you can get lost in. Many, especially those fascinated with the math and science of options, mean well but miss the forest for the trees.
We have read commodity newsletters and advisory services that take option spreading to a ridiculous, almost shameless bid for multiple commissions. Sometimes they may even look great on paper. But if the market would have to move somewhat higher or lower — yet not too high, and not too low — for the investor to make money after commissions, the same exposure could arguably have been achieved simply by buying or selling the futures contract outright. Trades like this violate just about every one of our red flags.
If a spread you are considering exhibits any of these characteristics, it is usually best to move on.
1
If the trade is too complicated to explain to somebody unfamiliar with commodities, you probably shouldn’t be in it. “If the price stays below this line through expiration, the trade makes money, after costs.”
2
There are some good reasons to use multi-option spreads. However, if you are going through the additional trouble and expense to implement a spread, it should be to tilt the odds greatly in your favor. This especially means that if everything expires worthless, you still win. If this scenario means you lose something, it’s simply a gambler’s bet.
3
As we’ve discussed, picking where the market is going to go is extremely difficult. Picking when it is going to go there is nearly impossible. We advise option strategies that require you only to pick where the market is not going to go. Seek out simple strategies that give you a very wide profit zone. The market should be in this profit zone already when you enter the trade. In this way, you force the market to move out of the profit zone for you to lose. Avoid all trades with very narrow profit zones or zones that appear far away from the current market price
Hopefully this has given you some real-life insight into option spreading and what to avoid. These examples by no means encompass every impractical, low-probability spread available for new traders to study, analyze and attempt to implement — nor every classic strategy designed by professional traders that remains impractical for all but the most highly skilled professional or floor trader. The guidelines here should, however, help you avoid the quicksand.
Now for some good news. In our experience, there are a handful of option spreads that are practical for the individual investor to implement — simple strategies that we believe can put probabilities in your favor and place you on more equal footing with the professionals. They are the reason this firm trades credit spreads. No strategy eliminates risk, and losses can and do occur. But the difference between a spread that is structured to work for you and one that quietly works against you is the subject of everything we do.
Risk Disclosure: Futures and options trading involves substantial risk of loss and is not suitable for all investors. Only risk capital should be used. The use of credit spreads limits the contractual risk of an individual position but does not eliminate risk, prevent margin calls or ensure profitable results. A credit spread may lose the full amount at risk, which may be substantially greater than the net premium collected. Commissions, fees, liquidity, execution, exercise and assignment may affect results. Past performance is not necessarily indicative of future results.
How we select markets, structure credit spreads, and manage risk on the sell side of the trade.
