Reduce Option Writing Risk with Spreads: Shubham Agarwal

Shubham Agarwal

A well-known fact for any Option Trader who got attracted to the segment for the first time is the extremely good success rate of Option Writing (Selling). At the same time, the first bad experience after starting Option Writing is the very fact that we can earn a limited amount, but we are at risk of an unknown amount of lose.

This makes Option Writing a dangerous yet lucrative trading system. Now what symbol, strike, and expiry one chooses to write is based on individual choice and analytical inputs. However, we all face the same huge risk that comes as a cost to a great success rate. Here, we will discuss the way this risk can be reduced without making a lot of changes to the success rate. This will be done in 2 steps.

Step #1: Converting the Unknown Risk into Known Risk

When we write Call or Put Option, we can not say with certainty to what extent the stock can go up or down at the most. This makes the risk of loss unknown. To tackle this, let me introduce spreads into Option Writing.

What are Spreads?

A spread is a combination of Options Trades where one Buys and Sells different Options of the same stock or index. There are a variety of spreads but for converting the unknown risk into known risk in Options Writing we will talk about particular types of spreads (Vertical Credit Spreads).

Vertical Credit Spreads are created by Selling a Call Option + Buying a relatively Higher Strike Call Option or Selling a Put Option + Buying a relatively Lower Strike Put Option.

In a nutshell, what we are trying to do is Buy a Higher Strike Call/ Lower Strike Put against the Call/Put sold.

Impact: The Loss of Writing is now Known & Limited to the difference between the bought and slod strikes minus the premium received after the Buy and Sell of those options.

Cost: The premium received is lower than expected because now we are spending some of the premium received in Buying a cheaper Option. This reduces our Maximum Profit.

But we can still make it more attractive, here comes the 2nd step.

Step #2: Now Write Higher Premium Call or Put.

Consider this example, if we were trading at 100, one would be inclined to Sell let us say 95 Put Option or 105 Call Option.

With this modification what is proposed is that we can now Sell 97.5 Put Option and 102.5 Call Option. This is because now we are not afraid of unknown risks. We can simultaneously Buy a 92.5 Put Option for the Put sold and a 107.5 Call for the Call sold.

Impact: Now the net premium received is more or less similar to the 105 Call and 95 Put and still the risk is much lower than the same Options sold because remember the Bought Options will also rise with Sold Options offsetting any loss partially.

Lastly, it even makes excellent economic sense because the Returns are better with Spreads. This is because once you do Spreads the margin requirement also falls dramatically.

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