Why use spreads as an option trading strategy in today’s stock market?

If you only buy options, the deck is stacked against you. Roughly 75% of options expire worthless or are closed at a loss. Since everything must add up to 100%, that means if 75% lose then only 25% win. If those odds sound good to you, you should spend a lot of time in Atlantic City or Las Vegas.

No one is right about the market 100% of the time. Sometimes things happen that upset your trading plan, such as 911, or Libya, or Congress not compromising and threatening a government shutdown or an oil spill in the Gulf. However, spread trading allows you to balance your risk and increase your odds of winning. It doesn’t matter whether it is a call spread or a put spread. If you buy a call and then sell a higher call on the same stock, you have balanced your risk. For example; XYZ stock is trading at $41.00 a share. The November 40 call is trading at a bid of $3.85 and ask of $3.90 and the November 45 call is trading at a bid of $1.70 and ask of $1.75. The total call spread is trading at a bid of $2.15 and ask of $2.15.

rnInstead of just buying the November 40 call at $3.85, you could buy the November 40 call and sell the November 45 call for $2.15, in equal quantities thus saving $1.70. If the stock rises as you expected, you could close the call spread for more than $2.15 which is a profit. If the stock price falls after the call spread is executed, you could buy the November 45 call for less than you received when you sold it, which is a profit and then wait for the stock price to correct (rise) and then sell the November 40 for more than you paid which is a profit on both sides (legs) of the call spread. The same concept would apply to a put spread.

rnCall spreads and put spreads reduce your cost and balance the risk. By being both a buyer and seller simultaneously, you have increased your chances of winning. However, this doesn’t substitute for doing your homework of technical analysis and fundamental analysis on the underlying stock to increase your chances to win. Turn your next option trade into a winning trade. Stop losing money trading options. Use spreads to mitigate the risk and get more consistent returns.

rnRobert E. Ross
CEO
Sweet Dreams Trading Company
www.sweetdreamstradingcompany.com