By John Summa, CTA, PhD, Founder of OptionsNerd.com
Now that you have obtained a solid foundation for underlying option spreads, here are some tips on how to use them. In this section, we'll focus on the use of orders, liquidity and some margin-related matters.
Spread trades, as a rule, should be established using a spread order, leaving legging into the spread (placing one leg at a time) to the pros. The possibility of having the market move against you while trying to leg in makes using spread orders imperative. But what type of spread orders should you use? Generally speaking, you should always work a spread order using a limit price to assure you get the desired price that will make the spread work out according to plan. For example, because there is a limited profit potential in many spreads, it is essential to get filled correctly, or not to get filled at all. Limit orders serve this purpose well.
In today's online trading environment, simple spreads can be placed with limit orders and filled without too much trouble. Of course, it is important to make sure the option strikes comprising the spread have enough liquidity, measured in open interest and daily volume. The options should have at least a few hundred options traded (on average) daily with at least as much open interest if you are doing spreads that may require removal of the spread when it gets into trouble, or the execution of adjustments.
If you simply plan to hold a debit spread (buying spreads) until expiration, then liquidity is not as important. However, be aware that the more liquid the market, the better the pricing. With little liquidity, the market makers tend to widen the bid-ask spreads, making achieving your profit objectives more difficult. Always examine option prices for a few days to get an idea of how they are being priced if you are not sure about what size the bid-ask should be. You can also compare the bid-ask spreads across stocks of similar price (but different liquidity) to evaluate how wide the market is.
In most of the spreads presented in this tutorial, margin requirements are straightforward. For example, if you were to sell a vertical credit spread like the IBM call credit spread presented in the previous section using the strikes that are five points apart, the margin on the account would be the size of the spread minus the premium collected. In this case, since we collected $120 in premium, the margin requirement would be $500-$120=$380. If we were to retain the entire premium collected as profit, the rate of profit on the required (and maximum margin) would be 24% (abstracting from commissions).
For debit spreads, the capital required to open the position is always the cost of buying the spread. All debit spreads are strategies that are bought, so there must be enough capital in the account to pay for the spread.
For diagonal spreads, the margin story is not quite as simple. If the spread is established in a futures options market, a margin system known as SPAN applies. SPAN margin offers the advantage of having the nearby short option in a diagonal call or put credit spread looked at as a covered option. In most equity options brokerage accounts, the short leg across months is margined as a naked option, which can significantly impact overall performance due to the extra margin that is required to trade the strategy.
Finally, when applying horizontal and diagonal spreads to futures options, you may be trading two underlying contracts. For example, an S&P 500 futures options June-September diagonal put spread would have the June trading on the June futures and the September option trading on the September futures contract. It is not a big issue really, but something to be aware of if you decide to explore options on futures as an additional arena for applying options spreads.
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