A spread is nothing but buy and sell positions in different strike options of the same underlying at the same time
Shubham Agarwal
Quantsapp Private Limited
They say option trading is tricky. One of the reasons why I have seen many people turning away from options is due to the very common enemy of time. To many, including me, it has happened.
The view went right but we still couldn't make money. Why? It was because we spent a lot of time in the position, typically more than 3-5 trading sessions.
Let us try and address this issue and make time a friend rather than a foe. Before we do that let us understand what we are dealing with here. The value lost in option premium due to the passage of time keeping the price constant is called theta decay. One must note 3 things about theta decay.- It is like death and taxes, happens with certainty regardless of market movement
- Theta decay is slow at the beginning of the expiry and picks up momentum as the expiry comes closer
- Most importantly, the theta decay phenomenon is negative for option buyers but is beneficial for option sellers
Now, the answer to the fury of option buyers against theta decay is spread. A spread is nothing but buy and sell positions in different strike options of the same underlying at the same time.
How does it help? Well, while an option that one intends to buy is killing the premium due to theta decay, it is getting compensated to a certain extent by the option that is sold.
What strike do we sell? The answer is relatively out of the money. Meaning, select a higher strike while selling option in call spread and a lower put while creating a put spread.
While this additional position benefits, it comes at a cost i.e. margin, for the short option, which could be close to the future margin. Also, it would cap the gain from the option bought.
Let us take an example. Suppose, I have bought a 1,000 strike call at Rs 36 for a Rs 1,000 stock. I intend to hold it for more than 3-5 sessions. I am looking at a target closer to 1,030. I sell a 1,050 call trading at at Rs 17.
Now let us say the stock goes to 1,030 in 7 sessions. While the rise in price is boosting the call but passage of time creates a dent on premium. As a result, 1,000 CE would be trading at around the same price of Rs 36, while the 1,050 call would be trading at Rs 8.
What we are trying to address is peculiar situations like these, where if I had just bought 1,000 call, I would not make any money. But with the spread, I am going home with a gain of Rs 9 over the underlying gain of Rs 30.
In case the stock was to shoot, I would get strike difference (1,050-1,000 = 50) minus net premium paid (36-17 = 19), which would be Rs 31, which is around where my target was.
The downside to this strategy is that gains are capped at Rs 31, but the upside is that the passage of time is getting funded, which is the best strategy for times when the market/underlying is consolidating.
So from now on, whenever the view is expected to go beyond 3-5 sessions, it would be prudent to resort to spread.
Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.