Most people who regularly invest in the financial markets are aware of the basics of options and how they work. But what many of them do not realize is how powerful this innovative financial tool can be.
By combining different options, investors can make profits while keeping their risks at a much lower level. One such combination of options is known as option spreads.
An option spread is a combination of two options of the same or different underlying securities, at different strike prices, and sometimes with different expiry dates. This combination is considered a complex trade in options, as against an outright purchase of a single option.
In an outright, you just have to deal with a single strike price and expiry date, which keeps things relatively simple. But in a spread, the complexity increase, but so do the benefits.
The key aspect of a spread is that you open up positions in opposite directions. These are referred to as the ‘legs’ of a spread. For example, you can buy a call option of a stock and counterbalance it by writing a call option on the same stock. Taking these opposing positions, will have you covered whichever way the market moves, and thus it will significantly reduce the risk that you are taking.
It may seem intuitively that a spread cannot make you any money, as whichever way the market moves, you would have a trade in a direction opposite to it that will lead to cancellation of profit and loss. But the opportunity to earn a profit arises from the fact that prices of different options move differently when the current market price of the underlying security changes or based on a number of other factors like time and volatility.
A smart trader can exploit these differences to make money without risking too much of his capital. This opportunity can be better understood when you learn about different dimensions of risk involved in an option. These risk dimensions are referred to as the Greeks.
There are several factors or dimensions that determine changes in the price of an option. These factors are measured using some key risk variables, which together are known as Greeks.
- The price of the underlying security is the simplest factor that makes the price of an option move. Delta is the rate at which an option’s price changes for every unit change in the price of the underlying security. Delta shows how sensitive the price of an option is to changes in the price of the security.
- Theta shows the relationship between the value of an option and time. It is the rate at which the option’s price changes with the passage of time. It may not be easy to understand why the value of an option should change with time. Think about it this way – as a loss making option position approaches its expiry date, there is a constantly decreasing probability that the position will turn profitable.
If there are 2 months left to expiry, there may be a strong possibility of the option making money, but when only 2 days are left to expiry, there is very little chance that there will be a significant change in the position. This has a direct bearing on the price of the option, and is referred to as ‘time value decay’ (more on this later).
- It shows the relationship between the value of an option and the volatility in the price of the underlying security.
Other than these three basic Greeks, there are two more that are less commonly used:
- Gamma is the rate at which the Delta of an option changes with per unit change in the price of the underlying security. It is the second order derivative of the value of the option with respect to the price of the security.
- Rho deals with the complex relationship between the price of an option and benchmark interest rate in the economy. It is the rate at which an option’s value changes with every unit change in interest rate.
An important thing to remember is that these risk dimensions can be added up when you create a spread. For example, when you buy and sell a call option, you arrive at a combined Delta for the two. This Delta can be negative, positive or neutral, depending on your net position.
If your net position is short call or long put, Delta will be negative (your position loses when the underlying security’s price goes up) and when your net position is long call or short put, Delta will be positive (your position gains when underlying security’s price goes up).
One of the simplest ways to create an option spread is to buy an out of the money (OTM) call option and to sell a further out of the money (FOTM) call option on the same security. First of all, the amount of premium that you have to pay for creating the spread is lower, as the premium that you pay for buying a call is somewhat compensated by the premium that you collect for selling a call. This is a major advantage over buying an outright option.
Now let’s say the price of the underlying goes up. In this scenario, the first leg of the spread will gain as you can exercise the option and sell the security in the market for a higher price. But the second leg will lose as you may now have to deliver stocks to the option holder by picking them up from the market at a higher price.
The net effect, however, is that you make money as the impact of price rise is greater on the long call in this case, as it is closer to the money. Of course, you will not make as much money as you would have if you had just bought an outright call option.
What if the price of the security falls? This is where the true advantage of the spread lies. If you had just owned an outright call option, you could lose a lot of money as the price of the security fell. However, in this spread, your losses will be limited as the second leg of the spread will gain.
Another key aspect that you need to consider is the impact of passage of time on your portfolio. Let’s say, the price of the underlying security doesn’t move significantly for a few weeks. There will be a rapid time value decay in your long call, but this will be offset to a large extent by the gain in the second leg with the passage of time.
This is because as the date of expiry comes nearer, and your short call remains out of the money, there is no incentive for the option holder to exercise the option and your premium collection remains intact. On the other hand, if you had just owned a long call, you would be losing a lot of money with the passage of time if the price of the security doesn’t go up.
It is clear that creating this simple spread reduces your portfolio risk arising from a fall in the price of the underlying security and time decay of the option value. Either of these factors could have caused significant losses if you had just bought an outright call.
Next Chapter: Vertical Option Spreads