Spreading—How Accurate Do You Want to Try to Be?

When we apply a hedge defense to a written option position, we are actually engaging in a form of spread trading. We’ve written some options, we’ve purchased some others against them, and this is the basic definition of a spread.Spreading or, more precisely, conducting a price arbitrage between two related markets, has been a popular strategy for a very long time, dating back at least to the Dutch tulip mania centuries ago.

Spreading is easy to employ as an offensive strategy. We might come to think that, due to summer weather developments or for other reasons, August soybeans will gain in price relative to November beans, and we’d therefore buy the August contract and sell short the November contract against it. We might believe that the price differential between British Royal Dutch (Shell Transport) shares and Dutch Royal Dutch shares will change, and trade accordingly.

Right now, however, we are concerned with the notion of spreading as a defensive tactic if one or another of our option positions becomes threatened, or when a position becomes profitable and we want to protect our gain to some extent.A spread defense for written options that involves buying options in other months than the month of the options we wrote is difficult to use, barring pretty specific conditions.

If we buy the same number of options in a further-out month than we originally wrote in the (presumably) nearby month, we convert our original net credit into a net debit, usually an impermissible action for a first defense, and we also sharply reduce our range of profitability.I will only employ this kind of spread, called a time spread or calendar spread, for defense if two separate conditions exist.

We want the options we originally wrote to be very short-dated, to have a very short time until expiration, and we insist that the IV of our written options be much higher than the IV of the options we purchase for defense, 15–25% higher or more.Even when the market meets these conditions, we’ll be taking on a good deal of risk of an unfavorable market move. If we apply a spread defense and the market moves sharply against the defensive long side of the trade,we may not have any means to recover the loss.

We will be in a position,again, of hoping that subsequent market movement will be in our favor.If we buy fewer options in the further-out month than we’ve written in the near month, in order to keep our position at a net credit, this is a better idea. If, also, the IVs of the short options are well higher than the IVs of those we purchase for defense, we might end up doing very well for ourselves,converting our temporary loss into a nice profit if the market trades in a moderate range until the short-dated options expire.

Our plan here is to sell back the options we bought if the market stops threatening the strike of those we’ve written, and to sit still if the market persists in its threat. This is still far from an optimum tactic, though, because in many cases we may be required to keep adjusting our position as the market bounces around,as a rule much more frequently than when adopting a hedge defense.

When defending, the more trading decisions we make, the lower will be our ultimate profit, almost all the time. Write it down.We could take a more exotic stance regarding spread defense, say, by examining diagonal defenses or delta/gamma-neutral defenses. What are these?These are tactics we retail traders want to avoid using, that’s what they are,and, no, I’m not going to discuss them here.

We can only manage these types of defenses successfully if we’re willing to monitor our trade more or less all day every day, and likely make lots more trading decisions. More work,more contest risk, and probably less profit? Uh, gee, no thanks. We don’t need to make life so difficult for ourselves. In defending written options,avoid a spread defense in favor of a roll or a flip, or of accepting a loss when it’s modest, unless the IVs of the options you intend to purchase are way lower than the IVs of those you’ve written.

Problem solved.Institutional traders are able to apply complex spread defenses for written options if they wish, because they have the computing power, the lower trading costs, and the personnel resources necessary to manage these defenses successfully, at least in a statistical sense. You and I do not enjoy these advantages. Go ahead, try a spread defense one time, under less than the precise conditions mentioned previously, when you’ve written some option(s) and the position becomes threatened. You’ll soon see what I mean, if it’s not already very clear.