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VIDEOOptions: Spreads Are Not Strategies
It's not the product, but the thesis that counts.
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One of the biggest hurdles is learning the various types of spreads, the risk characteristics of those spreads (i.e., the greeks), and how to think in terms of time, volatility and price, instead of thinking in terms of price only. One frequent misconception is that different spread types are strategies in and of themselves. A reader sent in a comment recently along these lines, the gist of which was “I took some serious losses trading spread type X; since then, I've been looking for a new strategy that has milder risk, so now I only trade spread type Y.”
But risk is a function of position sizing and risk management, not of a product or spread itself; the actual spread types are irrelevant. For example, the exalted covered call -- regarded by many clueless retail brokerages as a conservative type of trade -- actually exposes the trader to dramatic downside risk in the event the long stock leg goes to zero (an outcome that's become more familiar of late).
In contrast, the notorious short strangle -- with its naked legs and unlimited risk in both directions -- can actually be a viable tool if sized appropriately and used in conjunction with other spread types. A calendar spread purchased for $3.50 and a $5-wide iron condor with an initial credit of $1.50 have exactly the same amount of capital at risk. And so on. In fact, if your position-sizing and risk-management procedures are sufficiently flawed, it's possible to lose vast sums with literally any kind of spread or product. In this sense, absent considerations of risk management, every financial product is just as risky as every other one. If you risk some unseemly percentage of your capital on anything and the value of that thing goes to zero, does it really matter whether the thing was a vertical spread, a mutual fund, a corn-futures contract, a collateralized debt obligation or a Basquiat?
The other problem with this notion of being married to one particular type of option spread is that, well, it’s a terrible idea to be married to one particular type of option spread. Each type of option spread has distinctive greek characteristics (short versus long volatility, short versus long versus neutral directional bias, etc.), and a successful trader will be comfortable using multiple kinds of spreads, depending on what her outlook is for the underlying asset.
One reason traders marry themselves to particular spreads may be that they confuse a spread type for an actual strategy. But an option spread isn’t actually a strategy any more than buying a stock is a strategy. What matters isn’t the product that you use, but the thesis (whether a thesis about price, volatility or something else) that a particular product or spread helps you express. Options are a language for expressing financial propositions. Sometimes, the simplicity of your thesis (”I think this stock is going to go up in price”) warrants buying or selling the asset outright; in other cases ("I think this commodity will become less volatile and may go down in price over the next month”), derivatives are the only way to express your view. In other words, if you don’t have a thesis -- an edge -- there’s no reason to trade options or stocks or any other financial product. Choice of product should be governed by that thesis and it alone, not by illusions about which spread type is inherently more profitable or less risky.
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