By Steve Papale
I have a love/ hate relationship with my lawn. Every spring I envision a lush green carpet free of weeds and brown spots. But as the season progresses it seems I can’t keep up with the “disorder” that takes over. This year I decided I’m staying on top of things. Weed and Feed every 6 weeks as recommended and lots of water (here in the Midwest that has not been a problem this year). That’s the plan anyway. I’ll check back in the fall to report on how that went.
There is an obsession in the trading world with spreads. Don’t get me wrong spreads are great. They can be used for all kinds of trading strategies – both directional and non directional. Market technicians can customize spreads to take advantage of support or resistance lines on a chart. Market neutral traders can use long options to protect the risk exposure short options create. They tend to be lower risk/lower return strategies than outright calls or puts. You can create a bullish or bearish trade with varying levels of vega. They make a healthy snack (just want to be sure you’re paying attention). So we agree there are plenty of uses.
But is it always better to trade a spread instead of an outright call or put? Of course not. There are many times when trading the outright makes more sense than the spread. For example, for some short vega trades like condors and butterflies, a position can create a short delta due to vertical skew. Sometimes it makes sense to at least partially flatten delta by buying deltas. I have seen some traders buy call spreads to pick up the needed deltas. The idea being it is lower risk than buying an outright call. Well maybe, maybe not.
Let’s say you need to buy 60 deltas. You might buy six 10 delta call spreads. This seems like a conservative way to pick up the deltas. Short option against the long offsetting vega risk, etc. The alternative might be to buy three 20 delta calls. Let’s compare. First we have to buy 6 spreads vs. 3 outrights. Higher commission and slippage with spreads. Vega – depending on spread structure the spread could have lower vega risk, a benefit most of the time however if the overall spread we are trying to buy deltas for is short vega, we might not mind picking up some extra long vega to offset.
Finally if markets really shoot up, the outrights may perform better as they are uncapped on the upside. While spreads are a very important strategy in options trading, sometimes it just makes sense to keep it simple.