We’re taking a look at directional spreads, focusing on portfolio, risk, and perspective. As part of options trading strategies, we’ll look at selling spreads with a bullish bias, a bearish bias, and a market-neutral bias. These various strategies give you the ability to pick the tools most effective in the current market environment.
I do not know what the current market environment is when you are reading this. That doesn’t matter. Once you’ve learned various option strategies, you can then choose the trade that is most effective for your portfolio.
What Are Directional Spreads?
In the first options blog post, I did a general overview of the credit spread concept. There were no lessons in strategy, market analysis, and criteria formats. I only wanted to offer an overview of what the credit spread is, as well as offer a perspective as to when you may want to trade that spread.
Why did I offer that trade first? Why did I choose that one over the iron condor or the butterfly? For the simple reason that there are two types of options trades.
Yes, only two. Once you learn these two stock option trades, you’ll understand all other option spreads. With a solid understanding of these two trades, you’ll be able to construct all other option trades, including directional spreads.
That doesn’t mean you’ll have the knowledge or understanding of when to place all those other option trades. It doesn’t mean you will be able to run out and trade any option spread with success.
It just means that once you learn these two trades, you’ll realize that every other option trade includes pieces of a vertical or a calendar.
Understanding Directional Spreads
Vertical and Calendars are options spreads that can also be directional. What if you don’t want to trade the calendar? Then don’t. It’s in your best interest to understand the calendar even if you never want to trade it.
You may want to roll a position or trade something with different expirations. Then you need to understand how to price it and calculate your risk. What would happen to your position if the market turns against you?
The understanding and ability to comprehend the risks come from understanding how to trade the calendar. What are the trade concepts for trading the calendar?
Hence, I began this series with the credit spreads, and after the credit spreads, I’ll move into the calendar trade as we discuss directional spreads.
A Community of Traders
What we discussed in the last blog was how to construct a credit spread. To enter a credit spread, we’d sell a position with calls or puts. To exit the position, we’d buy it back or let it expire worthless.
This is a great way to begin trading options and a great way to begin trading the market, since it only requires a trader to have a solid grasp of market trends. Hence, the appeal of directional spreads.
Vertical Directional Spreads
With market bias, a new trader can develop a vertical options trade that fits their own portfolio and risk comfort level. Can you imagine being comfortable trading options?
You don’t have to “only” trade vertical spreads or “only” trade calendars. However, while you’re learning and practicing, you can build a larger portfolio.
Vertical options or directional spread trades can be entered with a very small account. How small is small to you? I trade a small account, around 2k.
Even with a $300.00 account, you can trade options effectively. The ability to take options trades effectively in a $300.00 account comes down to understanding the balance/counterbalance involved in options trading.
All trading strategies (in options or stocks) revolve around the portfolio. While I cannot determine your level of risk, and I cannot determine your level of “acceptable loss”, I can teach you how to measure risk.
I can teach you how to determine what trading strategy to choose for different market conditions. I can teach you how to size your trades to survive the trade you enter, including directional spreads.
Credit Spreads
Directional spreads, such as the credit spread, are a great tool for new traders who are directionally challenged. They’re also a great tool to use when you want to add some protection against a current position you have in the market.
One thing we need to discuss when looking at trading options is portfolio bias. If you have positions that are directional in the market, you don’t want to enter new positions that challenge that market bias. For example, a lot of what I’m teaching circles back to trading products built on sector ETFs or Index ETFs.
When we trade these products with a directional bias, we don’t want to enter new options trades that are betting against our current positions. If I have positions in QQQ that are bearish and in IBB that are bearish, I wouldn’t want to enter a new position in SPY that’s bullish.
Can you understand why? QQQ is an ETF based on the /NQ Futures market. That’s the NASDAQ 100 Index. I entered that trade with a bearish outlook on the overall market.
The IBB ETF is based on the NASDAQ Biotechnology Sector. It is again a bearish outlook on an entire sector of the market. If the NASDAQ is bearish overall, so is the S&P.
So is the Russel 2000. So is the NYSE. You wouldn’t want to take a bullish position in SPY if you’re overall bearish in the market. You will have placed yourself in a losing position.
If the market rallies, you have a losing position, and if the market falls, you have a losing position. You have effectively created a lose/lose situation.
Products
Has this concept settled in? This is important for developing a portfolio of products. Yes, products. You shouldn’t look at each of your trades individually, however, as another piece of your overall inventory.
This doesn’t mean you’re restricted from placing bullish trades in a bearish market or vice versa. Some products aren’t moving in sync with the rest of the market.
Multiple products are not sector synchronized or tied to indexes. Think of earnings, for example, or think of products that have a catalyst event like major news announcements.
A product like TSLA could have negative news and be bearish while the rest of the market is bullish. The whole market could be bearish while certain sectors may be bullish.
There are many reasons for trading contrary to the overall markets. However, you need to understand the reasons and understand what your trade means to your overall portfolio.
I’m not going to spend too much time discussing the balance/counterbalance of inverse markets, sector selection, or index correlation. I want you to think about what you’re trading.
How will that product affect your overall portfolio? If you trade index ETFs, stay within a market bias to avoid creating a lose/lose situation.
Trading Directional Spreads
When we’re trading various spreads, we need to use a common trading language. A “credit spread” is not a Bear Call Spread or a Bull Put Spread.
A “credit spread” is a vertical option trade. If you sold that position, it’s a short trade. If you bought that position, it’s a long trade.
So, this is what we’re going to call our trades. Not “credit spreads” but short verticals. We’re selling a vertical options trade and only need to name the side of the trade we are trading.
If we’re trading calls, then we’re selling a short call vertical. Vertical short call. Short put vertical. Vertical short put.
Let’s recap. I’m focused on teaching you the concept and theory behind vertical trades. The most accurate EM (expected move) is on ETF products, so I use them most often in our examples.
We’ve defined the language to have a universal understanding and a language for each product. I won’t refer to our trades as bull put or bear call spreads, but I will refer to them as credit spreads or debit spreads. That’s how the trade is defined in our broker platform.
Why Trade Directional Spreads?
When we’re slightly bearish, slightly bullish, or see price action in a consolidation pattern, we’d consider a short vertical trade. Why?
In a short vertical trade, we won’t participate in the price action. Do you understand what that means?
If I bought a call or sold a put, I’d participate in profits or losses as the price of the STOCK moved up or down. In a short vertical trade, the maximum profit is the total amount of the credit received.
The only thing needed for our short vertical to be 100% profitable is for price action to remain below our anchor option.
Another reason we may enter a short vertical is to hedge a trade. A great example of how to use a short vertical to hedge a trade is to attach a short vertical with a butterfly to create a ratio-butterfly spread.
On the call side, we could take a long butterfly position with a short vertical embedded, giving us a 1,3,2 trade or a 2,3,1 trade. This could offer us profits if the price fails to “pop” in our intended direction.
Suppose $SPY is trading at $270, and we have an EM of $13 in the next 35 days. We could open a butterfly with a short vertical spread attached to it at or near $283.
In this way, if the price stays below $283, we keep the credit and allow the butterfly to expire worthless. If price does make that move in our direction, then the butterfly is profitable.
We manage the trade. You could also take a hedge to reduce your overall portfolio delta exposure. (not a bad idea)
Directional Spreads Strategy
How long we take on the trade comes down to the strategy for getting into the trade. Every day, someone comes into our trading rooms and asks How far out do I go to enter a credit spread.
This is a very difficult question to answer because the question is incomplete. If they asked how far out I go to embed a credit spread into a butterfly, I could tell them 20-50 days is ideal, with a delta between 20-40.
You see, I had an answer once I knew what the strategy was.
Final Thoughts: Directional Spreads
Trading options and directional spreads is no different than trading stocks or futures. There are a variety of ways to take an options trade and a variety of strategies based on different market conditions. The ability to understand when or why we trade one type of strategy over another is critical to your ability to profit from the trades you enter successfully.
