What are Option Spreads ?

What are Option Spreads? 

 If we want to use full power and flexibility of options trading, we must spend time in learning what are Option Spreads. 

If you are buying a call or a put option, what you are doing is, you are trading in a single contract or we can say single ‘leg’. But if you are trading in multiple contracts or multiple ‘legs’ which are related to each other, it can be termed as a spread. So buying a call option and as well as selling a call option is one kind of spread. Similarly, buying a call option and buying a put option can be another kind of spread. 

Although spread trading seems to be pretty simple in concept, but it becomes more complex in practice as we need to take care of market movements and its implications on overall spread profit and loss. One might think that how is it possible to make profit or loss when simultaneously we are buying and selling a call, since both will behave in similar fashion with move in the market. Yes, you are right but the trick lies in choosing different strike prices. 

So according to your view of market, different kinds of spreads can be created. The benefit of creating a spread vis a vis a naked buying and selling of call and put is that it reduces your risk, considerably. And in trading options, if we are able to manage risk, we can be sure of profits. So to understand spread, we have different classifications. The most simple classification of a spread can be based on the option premium involved. 

With this classification, the spreads can be classified as :- 

1. Credit Spreads – Credit spreads are spreads which will give credit to your account in terms of premium. For example, if you are selling a call and selling a put, premium of both call and put will be credited to your account and hence this is known as a credit spread. Please bear in mind that for selling a call and a put you will require margin money in your account, which obviously will get blocked. But in terms of premium of call and put, you are getting credit and hence this is known as credit spread. 

 2. Debit Spreads – As the name suggests, if you create a position which is taking money from your account (in terms of premium), it will be a debit spread. For example – if you are buying a call and buying a put, you need to pay the premiums of both call and put to the market and hence the money will flow out from your account and hence it is known as debit spread. 

Things cannot be simpler than this. So, what are the different situations in which we create credit spreads or debit spreads. Or what kind of credit and debit spreads are there. Yes, its surly a next logical question but needs more explanation before we jump into any kind of conclusive statement. 

We need to understand another classification of spreads to get the whole concept in. As per this, again we can have two kinds of spreads :- 

1. Vertical Spreads – In case you are taking two positions of call (or put) in the same month for an underlying, it is known as vertical spread. For example – you may buy an 8000 call and sell a 7900 call of Nifty creating a vertical gap between the positions. Since you will be selling and buying both the strikes at different prices, it will give a play to gain or lose money according to the movement in the market. Similar positions can be made on put side also. Again, a vertical spread can be a debit or a credit spread depending on the strike prices chosen. (more on this in next post). 

2. Horizontal Spreads – In case we are taking two position in different expires, it creates a horizontal spread. For example, if we sell 8000 call of Nifty for May month and buy 8000 call of Nifty for June month, we have created a spread with limited profit and limited loss. This kind of spread is termed as calendar spread or horizontal spread. Again, as in case of vertical spread, horizontal spread can also be a net debit or net credit spread depending on the strike prices selected for creating the spread.

 More on spreads and benefit of trading in spreads, various kinds of spreads possible and what all we need to look at, while creating spreads will be shared in our next post. Hope you enjoy reading it. If yes, please share you’re your views. That gives us encouragement to share more.

www.theoptionschool.in

5 reasons why you LOSE money in stock markets

Stock markets are known for their volatile moves. If there are abnormal returns, there are abnormal risks also. But in spite of all the risks involved, it is the only place which can give exceptionally good results, if handled properly. So, what are those top reasons because of which one loses money in stock markets. Experience shows that market volatility is NOT the top reason for losses in stock markets. The so called black swan event occurs once in a while but traders lose money, almost every day! Let’s see why it happens.

REASON NO 1 - IRRATIONAL EXPECTATIONS

Talk to any new trader. What is his expectation of monthly returns from the market? If he is not an experienced trader, he will say I am happy with 25% returns per month. Now, for him this is a very very normal return because he is treating stock markets not like a business but a place to get rich, quickly. This very expectation will force him to trade in such a way that he will lose almost everything in few trading sessions! Yes, his lose is somebody else’s profit. Now even 10% per month means you are doubling your money every ten months!

Show me a business where you can do this. Show me a business where you can even get 50% returns every year. Extremely difficult. So, if we have highly abnormal expectations of profits from stock markets, we are BOUND to lose money. Because than, we will be enticed by so many SHARKS in the market promising moon with their so called research and software. Ask them, if they are able to generate such returns, why should they share their research with anybody else. Why then all the big business houses will do anything else?

So, we need to keep expectations that are achievable. And our experience shows, that if you are good with your strategies, 4 to 5 % monthly return is achievable but that doesn’t mean it will be consistently there for all 12 months! Still there will be months when you are not able to achieve this. Hence a yearly target of anything between 24% to 40% can be termed as a rational expectation. Yes, still it is very high compared to your fixed deposit in a bank.

And in the end, we will share a calculator with you which will show you, where will your initial investment reach in ten years from now, even if you achieve 24% returns per year.

REASON NO 2 – SHORT TERM VISION  

There was this client who enrolled for our guidance for derivatives market. After the closing of first day of trade, this person had a loss of Rs 75 /- in his overall account of approx. 5 lakhs. He called us and was sounding really nervous. Next day morning, when markets opened, he was in a profit of around Rs 300/-. We immediately asked him to close the trades and forget about trading in stock markets for some time. This is a real life example and this same person is now (almost after three years) one of our biggest clients.

Three years back, he was a trader who will panic even at a drop of hat. Now he is a mature, experienced trader who can take nuances of stock trading in his stride.

We must know, what are we trying to do with stock trading or derivatives trading. Is this like a fixed deposit in bank account wherein my money must grow every 24 hours – whatever small is the growth?

No, this is a place, where you require lots of patience.

‘Stock market is a device to transfer money from the impatient to the patient’ –  by Warren Buffet.

Think of a business man who has started a new business. He need to set up lots of things before he gets his first penny as a revenue forget about profit. Think of all these big ecommerce guys setting up their businesses and accumulating loses for years before they make their first profits. McDonalds was there in India for almost first seven years without any profits.

But these are visionaries. They are not here for a day or a month or one year. They have long term vision for their business and they will try everything before they give up – in case they give up, ever.

I am not saying we should also keep on accumulating loses after loses! No, but we should not have such a short term horizon for making money in any business. It doesn’t work that way at all in stock markets also. That’s why many times we hear this ‘most of the weak hands are out of market in recent volatility ‘. Do not become a weak hand who can be manipulated by market makers. Have a sufficiently long vision, so that there is no psychological pressure on you – the toll used by market manipulators to throw you out!

REASON NO 3 – NO STRATEGY / PLAN IN PLACE

Stock market is no more a casual occupation. We need to have a proper strategy in place to create any meaningful wealth. Strategy which is able to capture not only short term gains but also capture long term capital appreciation for your money.

If you have entered a trade without any plan on when to do any adjustment, when to book profit or when to exit the trade, this is not strategic investment. This is casual trading and when all the other traits of overall economy are becoming extremely tough, it becomes equally difficult to get positive returns from stock markets. So, trade without any strategy in place, it becomes a sure shot recipe for losing money.

Strategy as such is a word taken from military. Strategy means that I am ready to take care of my position with whatever limited resources I have. I don’t know whether the enemy will attack me from left, right, front or back but my strategic positions will take care of attack from any side.

Similarly, in stock markets, I should hedge my positions in such a strategic way that I need not panic for any kind of moves of the markets, which in case will always be there.

REASON NO 4 – GRAB THE NEWS & PREDICT

Glue yourself to TV screen and be rest assured, you will always lose money. A friend mine subscribed to a so called ‘insider’ for getting information about the market movements by paying a huge sum of money for one-year subscription. Now almost four months old, he is very clear about what to do with this information. At least to save his capital, he has stopped trading at all!

Every morning you have experts competing with other for your attention on different business channels. Try to follow them, you will come to know what is happening. Every other person is expert in predicting where the market will go.

 ‘If it goes by another 50 points from here, it is a bullish signal and it will touch 9000, and if it goes 77 points down from here, it is very bearish signal and it can touch 6900 !!’

Whatever happens to market, the expert is always right.

Do you think a normal retail customer will get the news before it is played out? No chance at all! Show me a person who has created any meaningful wealth by doing intra-day trading. Think about it. Who is gaining by your intra-day trading? You or some-body else!

Use whatever charts, software you want to use for predicting the direction of market, more than 50% of time, you are wrong. Why to waste your energies on something which you are sure, that it will be wrong 50 % of times?

Why should I be acting as a puppet in the hands of so called experts having opinion on each and every stock and each and every aspect of market?

No way I am denying the capability of some really genuine guys out there, who are giving fair view of overall situation, but they are very very small in number. And in the overall jungle of marketing gimmicks, difficult to identify them.

REASON NO 5 – NEVER INVEST IN YOURSELF  

We love to give advice and we love to take advice as long as it is free. But please check out. What is the cost of free advice in stock markets?

 It is huge. Cost of free advice is the huge lose that piles up in our accounts. No one is responsible for that because it was delivered free of cost. But still, unless and until we burn our fingers severely, we keep relying on the free advice of our intelligent colleague, smart neighbour, old friend, an insider of stock markets, our brokers and the list can be pretty long.

We regularly get phone calls from people from different parts of country, saying – I have lost huge amounts of money in stock markets, I want to learn hedging techniques, I want to learn positional strategies, but I cannot afford to pay.

Is it true? It is not that we cannot afford to pay. We still do not want to invest in sharpening our own axe. We do not believe in acquiring new skills which require some effort-mental, physical and financial. We don’t know what we don’t know. The unknown unknown box is pretty big.

But then there are hardly any low hanging fruits in these markets. A very successful person shared with me – ‘I always buy and read lot of books. Even if I get one good sentence from a book, the cost of book gets recovered. This is my investment on myself.’

How to trade for RBI policy on 5th April,2016 ?

Today RBI will announce its policy at 11:00 a.m.

How can we use this event for making some profits ?

There can be two scenarios :-

First - Markets move sharply in any direction due to some sudden surprise by the policy.

Second - Markets remain range-bound as there is no surprise in the policy.

In both the cases , there is one thing which will surly happen.

Implied Volatility of options will go down after the policy.


So, best method to trade in such an event is sell options on both sides. Yes a short strangle can be a great strategy, as after the event,  prices of both call and put may go down , considerably.

More conservative traders can create an iron condor , so that even if there is a big move in any one direction, there are no / small losses

We must take some precaution while  creating such positions. Most important is , we must ensure that  we are sufficiently away from the spot levels of market so that in case of any sharp move, none of  our positions get In The Money. In case we are able to achieve this, chances are very bright that we will be able to make profit only.

Because of such events, IVs always go up and after the event, irrespective of outcome of event, IVs go down. So if IVs will go down, option writers will be benefited. Since we know that markets may not make a significant move till the policy announcement, we can always initiate our positions just before the event.

If you are relatively new with option writing, just go for paper trading to understand the scheme of things.

All the best.

www.theoptionschool.in