Trading options can be extremely risky, potentially leaving a trader exposed to unbounded losses. One popular way to hedge this risk is to trade options spreads (or ‘complex orders’). A spread involves the simultaneous buying and selling of options on the same stock. A properly constructed spread trade can remove the unbounded nature of certain options strategies and allow traders to carefully define the amount of risk embedded in any given trade they make. At Android Alpha, spread orders form a significant part of our trading operations.
Options Spreads: An Overview
The best way to illustrate an options spread trade is by way of example. Let’s say it is mid March 2016 and Apple (ticker = AAPL) is trading for about $100 per share. Our protagonist trader believes Apple shares are going to fall in value sometime over the next 4 months, but he is not confident in the magnitude of the fall nor is he willing to risk a huge amount of capital on this hunch. One option would be to enter into an options spread trade. Consider the following two AAPL options contracts:
- $100 call expiring July 15th 2016; Price = $6.80
- $110 call expiring July 15th 2016; Price = $2.70
A call option gives the contract holder the right to buy the stock at the strike price (in this case $100 and $110, for the two respective contracts) on or before the expiry date (July 15th, 2016 in this case). Since the trading hypothesis is that AAPL stock is going to fall from its current value ($100) in the next 4 months, the trader could simultaneously sell the $100 call and buy the $110 call, bringing in a $4.10 credit ($6.80 – $2.70).
If AAPL is below $100 on July 15th, 2016, both contracts will expire worthless (i.e. one would not exercise a right to pay $100 or more for AAPL when one could buy the shares on the market for a lower price) and the trader keeps the $4.10 as profit.
Let’s say the trader’s prediction did not come true and AAPL in fact soared to $120 per share over the next 4 months instead. In this case, both options contracts will expire
in-the-money, since their strike prices are lower than the stock price. In this case, it pays for the contract holders to exercise their rights to buy AAPL at the specified strike prices, since they could turn around and sell AAPL at a higher price on the market.
Our trader owns the $110 call (he is
long this contract) and owes the $100 call (he is
short this contract). The counterparty (the holder of the $100 call contract) will almost certainly exercise their right to buy AAPL at $100 and the trader will exercise their right to buy AAPL at $110. Once the dust settles, the net effect for our trader is that they will lose $5.90, through the following cash flows:
- $4.10 credit at time of trade
- $100 credit at expiry, due to counterparty exercising the short
- $110 debit at expiry, due to trader exercising the long
Although the trader’s hunch about AAPL was wrong (it soared instead of sinking), his loss was limited to $5.90, regardless of how much above $110 the share price might have gone. In contrast, if he had simply sold the $100 call or shorted AAPL, his losses would have been potentially unbounded, since there is no theoretical limit on how high a share price can go.
The payoff from the spread trade is shown below:
I will leave it as an exercise for the reader to prove that the break-even price for the trader is AAPL closing on July 15th at $104.10. Above this value, the trader loses money and below this value, the trader makes money. The curious reader can gain more knowledge on spreads here.
So in theory, spread trading allows one to greatly diminish risks when trading options. In reality, there are many pitfalls to spread trading, many of which are not discussed in the myriad books and websites written about options trading. When Android Alpha launched in 2007, we were blissfully unaware of these pitfalls and unfortunately learnt about each and every one of these obscure risks the hard way, by losing money. In future posts, we will address some of these risks in the ‘unusual risks’ portion of this blog.