Chapter 5: Things to Keep in Mind when Trading with Spreads
Option spreads are unique and can give you some great advantages when you are looking to limit your risk. But there are a few things that you should keep in mind when trading in spreads:
- First of all, you should be using limit orders to trade in spreads. This will prevent a situation where you have got into the trade but at the wrong prices, which can completely ruin your strategy. You should set your limit orders in a way such that either you open up both legs of the spread or neither of them. The last thing you want is being stuck with an outright option having unlimited loss potential.
- Make sure that there is enough liquidity in the options that you are using as legs for your spread. You can check the liquidity of an option by looking at its daily trading volume and open interest. If there isn’t enough liquidity in the option, you would find it difficult to close your position at an appropriate time to maximize your profit.
- Even if you plan to keep the spread open until expiry, you could suffer from a lack of liquidity as it would open up the gap between the bid and ask prices. A larger gap between these two prices could be detrimental to your spread strategy.
- Finally, make sure that you fully understand the profit and loss consequences of the spread in all possible outcomes. There is no point in getting into a complicated trade that you don’t have a complete grasp of. If the market situation changes, you may have to make adjustments to your spread or even close out the position.
- In either case, you would not be able to make the right decision until you have a good idea of how the different risk dimensions like time, volatility, underlying price etc are acting on your spread. Before you jump into trades with high stakes, test your understanding by using mock portfolios. That will also teach you how to react to different market scenarios to make your position a winning one.