Reasoning Behind Spreads

Hello all,
I have been tracking your progressive on this long journey of "learning to trade options" via short updates from Bob. What I am observing (from afar) is that your meetings are being held back to the lowest common denominator of knowledge. I do not mean to be offensive in any way, but unlike the IBD meetings where the intent is to be able to discuss the market and evaluate some potential trades, I believe the Options Group would like to be able to actually learn how to trade options. That is an entirely different objective and requires some structure and meeting objectives in order to move ahead.

I suggest that you find a course, any course on trading options that you can all follow along as a discussion guide. You have to be able to at least get through the basics as a group or you will never go beyond rehashing what a "put" is every meeting.

That brings me to my title topic. Options were developed as a hedging device for stocks.  Because we can also use options against indices, etc., we use the term "underlyings" with options. As options have evolved and grown in popularity, they have been used solely by themselves without owning a specific stock at all. That is where spreads came into play. The spread becomes a hedge using just options. This is very important because trading single options can be very risky. By using a combination of longs and shorts, calls and puts, we can define the risk to an acceptable level.

This can get very complicated. It is not simple. It is not something you learn at a weekend seminar.  It is also not "Rocket Surgery" (a Bushism).  Its' complexity comes from having so many variables that can effect your profitability.  With stocks, they either go up, sideways or down.  The key to options, is understanding how to take advantage of whatever the market gives you.  The more you understand how the options instruments change with the market, the more prepared you are to act upon that advantage.

To gain this advantage, it helps a great deal to understand how each individual segment of the spread acts under different market conditions. As part of learning the basic mechanisms, I encourage you to disect each of the four instruments (long call, short call, long put, short put) using the TOS analyzer, to see how they react to market changes and what they contribute to your profits.  Take notes on your observations and share them with the group.  Once you have done this, you can move on to combining the individual segments into spreads and seeing how they behave as well.

The thing to remember is that options are simply "premium" for a risk. An option is made up of: the value of the underlying, volatility (perceived risk) and time exposure. That's it. You change any of these three and you change the premium. It is very easy to enter one the four instruments into TOS and then manipulate these three variables while observing the effects on the premium. This way you learn the "personality" of the instrument. You make your observations using the graph above and the "slice" lines below. The three Greeks you use are Delta for the value, Vega for the volatility, and Theta for the time. You can change any one or all of them. 

You absolutely have to learn how the Greeks work, because later on you will manage your portfolio using the Greeks.  Depending upon market conditions, you will want to add or subtract Delta, Theta or Vega by adding or closing different types of trades.

I have told Bob that if you get on a structured learning process, I would be happy to come in and help get over some of the rough spots.

Good luck on your journey,

Tom