The Option Pit Method Options Made Easy 4

The Option Pit Method Options Made Easy 4 Option Spreads

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What you will learn- Course 4 • Why use a spread? – Controlling volatility and margin risk • How does volatility effect a spreads? – Taking a risk out of play • Why a long spread or why a short spread? – Focus on making money • Why use a complex spread? – Take ‘direction’ risk out of play

Directional Check List • What is the Story • What is the Directional Opinion • What is the Speed • What is the Implied Volatility • What is the best strike? • What is the best term to buy • What is the Best Spread? Course 1 Course 2 OR SELL? Course 3 Course 4

NVDA call spreads

NVDA calls

Calls versus Call Spreads

Why trade spreads? • Huge reduction in vega (volatility risk) – Vega risk is a change in p/l for a 1 point move in volatility for the options • Huge reduction in dollars at risk – A spread caps the risk so we focus on return for those dollars at risk – 80% of spreads dollars are at risk overnight

Understanding and Matching Expectations • Spreads by nature have lower expectations – We expect some movement but not a lot since a big move does not change the payout much • The long spread likes a move in the direction but really needs to be close to the money • We buy these for a particular direction with less volatility risk • The short spread does not like a move in the direction and wants to be far out of the money • We sell these spreads for a drop in volatility and direction

Skew

Notes about Skew • Each option has a unique implied volatility for any strike in the cycle • Put skew usually gets more expensive as the strikes drop below the money • Call skew usually gets cheaper as the strikes rise above the money – What this means is that after a point, there is diminishing returns on a spread

Rules for setting up spreads • For long spreads- start at least 1 straddle width from the long side and work out – Look for skew to give some hint on what you give up for the distance we go away from the money • For short spreads – Place the short strike at the edge of the straddle and work out – Look for a 15% return on real risk minimum

Some Tricks to Spread Buying • Put spreads are usually very cheap for the dollar and don’t decay very much – They make great hedges for long calls – Better short term since time kills the short put • Call vertical spreads generally are poor trades since they give up skew and take quite a while to generate dollars – The exception is any time the skew slopes “upward” for the calls – Could be good in “covered call” position mid-term • Let’s we an example of a Tweener

Delta

Deciding what to trade • The decision tree for Making Options Easy starts here: – Either call spreads or put spreads, long or short are mostly about direction (delta) • What we decide on for the spread is “how right” we have to be for the trade – 100% right TO 25% right (look at the delta) » How OTM are we or do we need to be? – Let’s try to optimize with NVDA spreads into earnings.

NVDA

NVDA volatility

Recall-Simple Option Movement • With these simple rules we can set up basic buy and sell decisions over a period of time. – The ATM straddle – this is helpful in estimating the markets best guess for a move TO EXPIRATION – The 1% Rule per day- A 1% move per day equates to a 16% volatility close to close • If you sell a spread, how fast can it get there? – Let’s work that out

Expected Moves

Spreads and Volatility • The higher the implied volatility the more likely we are to look at some kind of spread – Spreads take the real risk from 2 Greeks to 1 • Buying OTM spreads only make sense if there is a longer period of time, say 1 month or so – Time is volatility – For a giant move, buy an option • ITM spreads can take a lot of short term volatility risk out of play

Complex Trades • The trades are not complex, just more than 2 legs – This can be butterflies, condors, protected time spreads, pairs, etc • Multi-leg trades are best when we want less direction and more of a bet on volatility – We change or game from direction of underlying to direction of volatility

In Review • • Spreads are mainly for risk reduction The key spreads really is ITM or OTM Spreads crush volatility risk Complex spreads help reduce delta risk

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