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, bearish bias, and 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.
In the first options blog post, I did a general overview of the credit spread concept. There were no lessons in strategy,
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 options trades, you’ll understand all other options spreads. With a solid understanding of these two trades, you’ll be able to construct all other options trades including directional spreads.
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 spreads.
The understanding and
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 is 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 trend. Hence the appeal of directional spreads.
They won’t tell you when to take profits or what position size to take. Instead, they’ll share with you their personal trades, market analysis and market trend. They may even show you where they took the trade and what size of trade they entered.
Vertical Directional Spreads
Vertical options or directional spreads trades can be entered with a very small account. How small is small to you? I trade a small account, around 2k.
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 (check out our learn options trading page).
Directional spreads such as the credit spread is 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 ETF’s or Index ETF’s.
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. Obviously, I entered that trade with a bearish outlook on the overall market.
The IBB ETF is based on the NASDAQ Biotechnology Sector. It again is 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 into a losing position.
If the market rallies, you have a losing position and if the market falls you have losing positions. You have effectively created a lose / lose situation (watch us trading live the markets each day in our trading rooms).
Has this concept settled in? This is important to 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
There are multiple products that 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 over-all markets. However, you need to understand the reasons; understanding what your trade means to your over-all portfolio.
I’m not going to spend too much time discussing the balance/counterbalance of inverse markets, sector selection, or index correlation. I just want you to think about what you’re trading.
How will that product affect your over-all portfolio? If you trade index ETF’s, 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.
We’ve defined the language to have a universal understanding and 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 max 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 really 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 price fails to “pop” into 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 price stays below $283 we keep the credit and allow the butterfly to expire worthless. If price does make that move into 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 their question is incomplete. If they asked how far out do 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 how I had an answer once I knew what the strategy was? Take our options trading course to learn more about directional spreads and other options trading strategies.
Trading options and directional spreads is really 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 in your ability to successfully profit from the trades you enter.