Novice spread question ...

Discussion in 'Options' started by neophyte321, Apr 27, 2006.

  1. neophyte321

    neophyte321 Guest

    I've been developing what I hope is a high-probability entry/exit system, and I think I have it ... (been crunching data for months and months...) Its nothing revolutionary and quite simple, it's based on trend strength, and trading ranges. (May be as high a 75% potential win rate .... still researching)

    I'm now looking at option strategies, and the simplest one seems to makes the most sense and is the most profitable. Long puts/long calls.

    Why use bull/bear call spreads if you risk $200, to makes $200 and risk $200? Such as is the exmple at the link.

    Why not just bet the $200 and put a stop at $100.

    Sorry about the simplistic nature of the question, I am after-all a neophyte, ... and proud of it.
  2. The only difference between the two is that vertical spreads are hedged positions; one leg hedges the other.

    As a result, all of the sensitivities (greeks) of the position are muted compared to a comparable single put or call. This might translate to a smoother running PnL for example.

    Whether to spread or not all boils down to the particulars of your system and likely magnitudes, timings and probabilities involved.

    Some would argue that you are better off going with singles to avoid the inherent extra loss in "edge" in trading two legs over one. However, depending on the spread you choose, it may be "nominally" quoted so as to not be any more disadvantageous from an "edge" loss point of view.

    You can adjust the risk/reward of the spread as required by choosing different spread widths and different strike proximities etc.

    As a middle road, you may want to consider legging into the spreads in order to lock in a profit but allow room for more. This entails going long the single in the first place and then shorting a subsequent option to complete the vertical.

    To summarize: how much conviction do you have in your system and therefore how much of a hedge (spread) do you want to have in your position?


  3. neophyte321

    neophyte321 Guest

    MoMoney, thanks alot for the detail. It is suprising the level of help others provide in this zero-sum-game!

    As for probabilities of the system, can't say exactly, but in all honesty, I'm shooting for 75%+ win/loss. I've developed a method to rank trends, across the 1500 stocks I track. I look for the strongest trending markets, currently trading outside their ranges.

    Legging into the spread sounds promising. I'll investigate this.
    I'll probably long puts/calls, put a stop at 1/2 the money, and considering legging into spreads upon big moves. In addition, I'm looking for cheap contracts, those whose IV is lower than HV, and the volatility I forcast.

    I think I might be able to pull this off. I'm 3 for 3, now that I've begun to take this seriously.
  4. jj90


    Stops don't always work. And long vertical spreads with a payoff of 1:1 is a bad vertical spread. A better profile is the payoff should be at least 2:1. But hey, keep us updated on your system.
  5. Can anyone explain how do prices change in a spread? For example, we've bought a call for $2 and sold one for $0.50. If price move up lets say our bougth call grows to $2,50 but the sold one should also change to $1. So the difference is still $1,50. And when we close our spread we have nothing. Where I'm wrong? Just investigating the question. Thanks
  6. DJR


    as a sugestion to anybody posting option questions. i have traded them for years (in equities) as both a position trader and a market maker so i have a handle on both sides of the equation and would like to help. but the best thing when posting questions would be to also give the expiry months and strike prices of the options mentioned. As well as the underlying price.
    these make huge differences in the outcomes.
    Options are RELATIVE instruments. there are many factors affecting their prices. from the underlying, volatility, interest rates, dividends, time. How they move does depend on when they are relative to many things.
  7. Thanks DJR.
    Newb's like me will need your help for sure :).
    I meant nothing specific. I just see that options with different strikes (even close ones) change differently. And thought before they were highly correlated.

  8. ozzy


    Guys, I recommend you read "Option Volatility and Pricing" by Natenberg everything you want to know is in there. Read it a few times until it sinks in fully.
  9. DJR


    options are highly correlated. the amount an option price will change by compared to other options though is determined by many things. for a vertical spread in the same month. the most obvious determinant on the price will be the underlying. how much an option changes by is given by all the 'greeks'.
    for a quick and easy check look at the delta of the option. if it is 50 (or .5 for different terminology) then for every one cent the stock underlying moves it will move by .5 of a cent. if you do a spread whereby the long option has delta 50 and the short option has a delta 30. then as a ready reckoner the spread has a delta 20. Thus the spread will change, but by much less. remeber though that the delta of each option and hence the spread also changes slightly over a daily basis, due to time, depending on if they are in the money or out of the money.
    basically read a couple of books, but more importantly if you are serious about options trading. get a good options modeling program. (the best cost less than $100). run though on a daily basis what happens to option prices as variables move. it will be the best and cheapest lesson you can receive. a book can teach you theory and most of it is based on expiy day, little is based on real life
  10. Thanks DJR,
    your explanation is very simple and useful. I've found Natenberg so starting reading. By the way, which program would you recommend? And more, is there any way to see historical data on options (with greeks, IV, price etc.)?
    #10     May 2, 2006