Monday, February 8, 2010

Spreads vs. Longs/Shorts

So I know we've talked in the past about the benefits of the defined risk/rewards that spreads offer versus just being long or short the options, and we've talked about the differences between paper trading and actual trading. Now that I've had some experience with actually trading spreads this is what I've learned: the defined risk/reward of a spread really only applies if you carry that trade until expiration. Between the changing volatilities, large BxA spreads, and depending on how much time is left, your underlying could be exactly where you thought it would be but you can't exit the trade for the profit you anticipated.

Example: You buy the 100/105 3-month call spread when the underlying is at 100, it shoots up to 105 tomorrow. Because your moved happened faster than anticipated you still have roughly 90 days until expiration so closing out the trade will not yield the max $5 of the spread. Had you just bought the 100 long you can close that out for a minimum of $5 intrinsic value. A personal real world example for me is I have a bull put spread on SPY 106/105 for this month, I think I paid .25 for it. During the dip on Friday the SPY went below 105, but I wasn't able to capture the max .75 profit on the trade because vol increased, the BxA spread increases as we're headed down fast, and I've still got 14 days to expiration. I've also got a MET bull call spread 12.50/30 and the stock has been above $30 for months, but the wide BxA spread and theta left in that trade only offers me a return of $15 instead of $17.50.

So my takeaway that I'll keep in mind when pursuing spreads in the future is to understand that if you want to take the trade off early you'll have to leave some of the profit on the table. You alternative is to take on more risk and just go long or short instead of using a spread. I don't believe this is a right or wrong scenario, just a risk/reward trade off.

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