Why Try Spreads

A few weeks ago, we received a request about using put spreads for hedging. Since our last comments on spreads are more than a year old and market conditions have changed this seems like a good time for an update, but first, a brief note about our usual Market Review. Last week the S&P 500 Index made multiple new closing and intraday highs while our tactical indicators improved slightly and remained quite bullish. Last Monday's Digest Issue 6 "Don't Worry, Be Happy [Charts]" continues doing a good job describing the current condition.

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Option Spreads

First some common terminology. When completed with a debit, the practice is to refer to a spread as a long position. Alternatively, when completed for a credit it's called a short position.

Initially attracted by the advantage of leveraging small commitments with the potential for large gains, single option positions also come with additional risk beyond getting the direction right. Since options expire, they continuously decline in value and the closer to the expiration the more rapid the time decay. In addition, option values change as implied volatility changes.

Spreads greatly reduce both time decay and volatility risk while maintaining the direction opportunity. Further, they define the risk while also limiting potential gains.

Referring to options characteristics, commonly called the "Greeks," some have positive values, others such as time value or "theta" have negative values. By combining a long option with a short option the positive and negative values are partially offset depending upon the "moneyness" or the amount the strike prices are in, at, or out-of-the-money. Of course, spreads can have more than two legs in various ratios such as 1:2, or 2:3 or other combinations that significantly alter the "Greeks" and the risk profiles.

Using 1:1 spreads for direction trades or hedging existing long positions, allows the initial debit or credit to be limited and defined while the maximum potential value can be calculated based on the distance between the strike prices of the legs. For bullish call spreads or bearish put spreads, a debit of about one-third of the distance between the strike prices makes a reasonable guideline and will typically be found using out-of-the-money strike prices.

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Disclaimer: IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter ...

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