Why Options AI Does Spreads
MULTI-LEG OPTION SPREADS CAN BE A SMART WAY TO LOWER COSTS AND HELP IMPROVE PROBABILITY OF PROFIT WHEN LOOKING TO ADD THE POWER OF OPTIONS TO YOUR PORTFOLIO.
Options can be a powerful tool for investors both as a leveraged alternative to stock and for adding income or protection to a portfolio. But finding the right balance of risk, reward and probability can be a tricky process, for even the most seasoned investor. And, advanced traders know that if you’re not selling options then you’re missing half your toolkit – the half that often unlocks the opportunity for higher probability outcomes.
But simply selling options outright can also present undefined risk and therefore unlimited losses. A risky prospect that rightly deters many investors. This is one reason why institutional investors will often simultaneously buy and sell options as part of an options ‘spread’. To optimize for probability while also ensuring that risk is defined. And why we, at Options AI, built an options trading brokerage where spreads are as straightforward as buying a stock. Helping simplify the path to smarter trading for our community of savvy investors.
The Case for Selling Options
We know that buying a Call (or Put) option means we will see potentially uncapped gains if the underlying stock moves above (or below) our breakeven at expiration. Breakeven being our options Strike Price plus (or minus) the Premium we pay to buy the option.
Premium (the ‘price’ or ‘cost’ of an option) reflects, amongst other things, implied volatility or the magnitude of move in the underlying stock expected by the options market. During periods of increased stock price volatility or around binary events such as earnings, options premiums may be elevated, leading to a larger Expected Move and higher (or lower) breakeven levels. But in all market conditions, it is the role of market makers and other options market participants to ensure that premiums accurately price future underlying stock moves.
It follows therefore, that in order to realize any profit when buying options, not only do we need to be right on direction, but we also typically need a magnitude of move greater than what the options market was pricing or expecting. In other words, we don’t just need to be right, we also need for the options market to have been wrong.
Therefore, as option buyers, we often accept a relatively low Probability of Profit (“PoP”) in return for the potential of outsized and uncapped gains.
Turning this on its head, if buying options typically means lower PoP, then selling options and collecting premium should mean higher PoP. While this generally holds true and therefore sounds compelling, it is important to remember that we are short rather than long options, we are also substituting our potential for uncapped gains with the potential for unlimited losses. Without defining our risk when selling options, when things go wrong, they can go very wrong.
The Case for Selling Options in a Spread
By reminding ourselves of the basic trade-offs in risk, reward and probability when either buying or selling options, we immediately get a sense of why, combining the respective advantages of both buying and selling options, might allow for something altogether smarter.
Spreads, or the simultaneous buying and selling of options to create multi-leg positions, are favored by institutional investors for this very reason. The opportunity to define risk, lower cost and improve probability of profit whether seeking income, leverage or protection from options.
While others see spreads as complex and time consuming, at Options AI we see spreads altogether differently…