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Options trading: When to use a spread Add to ...

I often utilize option strategies that lean toward selling options. There are some very simple advantages to this. First a selling strategy gives us favorable theta decay. The time erosion works in our favor. It is a lot easier to predict that there will be 31 days in January than it is to predict the direction of the market. January is guaranteed to have 31 days but stock direction is never guaranteed.

Second, the probability of an option expiring worthless is higher than the odds of getting the stock direction right. Picking stock direction is about a 50 per cent coin flip kind of bet, but selling options profitably can be as high as a 99 per cent bet.

Given those advantages the key for an option trader is to know when to put on a protective hedge to manage the risk. For example yesterday I put on a trade in Chipotle Mexican Grill . We sold the March 270 puts with the stock trading around $340 (U.S.). Let us look at the possibility of buying a further out of the money put as a hedge to limit our risk.

We will take, as an example, the March 265 put. We could buy it for $3.10 using Thursday's closing quotes. We could sell the March 270 at $3.20 for a net credit of $0.10. Part of the reason the net credit is so small is that we pay two spreads. We also pay two commissions which would further eat into profit potential. I always look at bid/ask spread to see if trading a spread strategy might make sense.

Another thing I review is the relative valuation. When we trade options a good way to decide if an option is overvalued is by looking at its implied volatility. First compare it to the recent historical or actual volatility for the stock. The implied volatility is the market's own estimate of the future volatility of the underlying stock. Usually the option volatility is higher than the historical volatility, but it should not be too much higher if we are going to use it as a long hedge.

The next valuation comparison is to look at the implied volatility of the option we are selling compared to the implied volatility of the option we are thinking about buying. In this case, the BIVcolumn stands for Bid Implied Volatility. The BIV for the March 270 put is 0.4191. The AIV stands for the Ask Implied Volatility. We can see that the AIV for the March 265 put is 0.4401. So if we do this spread we are selling at 41 per cent volatility and buying higher at 44 per cent volatility. This is a relationship which works against us.

The final consideration is based on return on margin. When we do a credit spread the margin requirements are reduced to the difference between strike prices at most brokers. So the requirement is only about $500 in this case. But it is also true that the net credit is greatly reduced as well. In this case we are getting only a $10 (0.10) return for investing $500 in margin. Compare that to the return of $320 on something like $2700 in margin at some brokers. I think it is clear that just writing the put naked was the better choice.

Phil McDonnell is a professional options trader and a member of the TheStreet's OptionsProfits Team.

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