Use Option Spread Trading to Profit from Neutral Markets

I have explained several main advantages of option spread trading in a couple of previous articles. (here and here). Some of those advantages are the ability to control a large security or a contract with only a small amount of money and reduction of risk.

Another option spread trading advantage is that traders are almost invisible to the market. If I decide to go long and buy a lot of calls on Alphabet, Inc. or copper futures, my trades, and trades of other traders, are aggregated and reported. Other investors can see in which direction the market is moving and adjust their own trading accordingly. Therefore, large volume of calls or puts can have a significant impact on the direction of the overall market. However, through options spread trade I can go both long and short in the same market and not affect the direction of that market.

Neutral spread strategies

To make a profit with basic option calls or puts, the market needs to move. Another amazing advantage of option spread trading is that I can now take positions in markets where I am not sure of the direction of the underlying security. In most examples of option trades, the price of the underlying stock or commodity had to go up or down to make a profit.

With options spread trading, I do not have to make a call on the direction of the underlying security or commodity price. I can simply use a neutral spread strategy to enter an option trade that will generate profit as long as the price of the underlying security remains the same. Neutral spread strategies are almost entirely foreign to options buyers who only know about calls and puts but do not understand spread strategies.

Spread trades generally offer less volatility than picking one side or the other of a trade. When I enter the long side of a trade with calls, the volatility in that direction can be extreme. If I have decided to protect my position by entering a bull call spread instead, I have at least some protection on the other side of the trade. I also limit my losses relative to strictly going into a call option.

Slippage

Unlike selling and buying basic calls and puts, I am no longer too concerned about how quickly my orders get filled — slippage — when I engage in option spread trading. Slippage can be quite severe in some markets.  Some markets might have very low volume. Other markets might lack enough buyers or sellers to clear the market.

However, with spread trading I am not concerned about the exact price at which I enter each trade because these are hedged with my other side of the spread trade. The other assumption is that both sides of the trade may incur similar levels of slippage, balancing each other out.

One of the best features of spread trades is that they do not create greater probabilities of losing in all cases. In certain cases, spread trades will create greater odds of winning, but not in all cases.

Disadvantages

While I am obviously positive about the benefits of option spread trading, I am fully aware of some disadvantages.

• Options spread trading can involve higher commissions because you are adding additional trades to the mix. However, if the premium of the price you receive for one side of your options spread trade is significant enough, the commissions become a non-issue.
• Options spread trading can lower your maximum profit if you put on credit options. You can also limit the amount of maximum profit if you have hedged your position. Another drawback is that you often need to hold options until expiration.
• The possibility of assignment or exercise with option spread trading is a bigger concern than with basic call and put trading. Doubling the number of transactions exposes us to a higher risk. I mentioned in a different article that assignment or exercise happen about 17% to 20% of the time. This is something investors must consider when making trading decisions. Some markets are more susceptible the other markets to option exercise and assignment. It is less likely that a trader will exercise options in the commodities market. In the stocks market, the probability is higher that somebody will exercise their option and demand the shares.

Each investor must evaluate individual goals, trading strategies and risk tolerance. Some investors will manage the risk and do well with option spread trading. Other investors might not be comfortable with the level of risk and will seek to generate profit with other forms of investments.

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Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.