This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

When to Use a Spread

This complimentary article from Options Profits was originally published on December 30. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 10 experts. Click here for more information.

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% coin flip kind of bet, but selling options profitably can be as high as a 99% 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 (CMG). We sold the March 270 puts with the stock trading around $340. 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% volatility and buying higher at 44% 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.

OptionsProfits can be followed on Twitter at

At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
CMG $460.14 0.00%
AAPL $94.02 0.00%
FB $104.07 0.00%
GOOG $683.57 0.00%
TSLA $162.60 0.00%


Chart of I:DJI
DOW 16,204.97 -211.61 -1.29%
S&P 500 1,880.05 -35.40 -1.85%
NASDAQ 4,363.1440 -146.4150 -3.25%

Free Reports