Managing Call & Put Spreads

💡 Mastering Risk: Call & Put Spreads

In this lesson of the Masterclass, you will learn about:

  • Call & put spreads
  • Risks of basic option spreads
  • Understanding and managing them
  • Important considerations for both

Long Call Spreads (Bull Call Spreads)

A long call spread involves buying a call option at a particular strike and selling another call option at a higher strike on the same underlying cryptocurrency, both with the same expiration date. This strategy profits from a moderate upward move in the underlying.

Risks of Bull Call Spreads

  • Limited Upside: The primary risk is that the underlying cryptocurrency surges past the higher strike, capping the maximum profit.
  • Lack of Significant Upward Movement: If the cryptocurrency remains below the lower strike or declines, the spread can result in a maximum loss, which is the net premium paid.

Managing Bull Call Spreads

  • Timely Exit: Consider closing the spread if the underlying approaches the higher strike or if a significant portion of the maximum potential profit has been realized.
  • Monitoring Market Sentiment: Keeping an eye on market news, regulatory changes, and other factors can help in anticipating potential price moves.

Bull Call Spread: Inherently a lower risk strategy, the largest risks come from price surging beyond the higher strike, or simply remaining below the lower strike.

Short Call Spreads (Bear Call Spreads)

A short call spread involves selling a call option at a particular strike and buying another call option at a higher strike on the same underlying cryptocurrency. This strategy profits from a lack of significant upward movement in the underlying.

Risks of Bear Call Spreads

  • Significant Upward Movement: The primary risk is a sharp surge in the cryptocurrency past the higher strike, leading to maximum potential loss.
  • Early Assignment: The sold call can be assigned if it goes deep in-the-money, disrupting the strategy.

Managing Bear Call Spreads

  • Rolling: If the underlying approaches the higher strike, consider rolling the spread to a further expiration or adjusting the strikes.
  • Hedging: Using futures or the underlying cryptocurrency, hedge the position if the market starts trending strongly upwards.

Bear Call Spreads: This strategy profits from a lack of significant upward movement in the underlying, the main risk being a sharp upwards surge.

Long Put Spreads (Bear Put Spreads)

A long put spread involves buying a put option at a particular strike and selling another put option at a lower strike on the same underlying cryptocurrency. This strategy profits from a moderate downward move in the underlying.

Risks of Long Put Spreads

  • Limited Downside: The primary risk is that the cryptocurrency plunges below the lower strike, capping the maximum profit.
  • Lack of Significant Downward Movement: If the cryptocurrency remains above the higher strike or rises, the spread can result in a maximum loss, which is the net premium paid.

Managing Long Put Spreads

  • Timely Exit: Consider closing the spread if the underlying approaches the lower strike or if a significant portion of the maximum potential profit has been realized.
  • Monitoring Market Sentiment: Staying updated on market dynamics can help in anticipating potential price moves.

Managing Positions: If a significant portion of the maximum potential profit has been realized, it can be beneficial to close the position early.

Short Put Spreads (Bull Put Spreads)

A short put spread involves selling a put option at a particular strike and buying another put option at a lower strike on the same underlying cryptocurrency. This strategy profits from a lack of significant downward movement in the underlying.

Risks of Short Put Spreads

  • Significant Downward Movement: The primary risk is a sharp decline in the cryptocurrency past the lower strike, leading to maximum potential loss.
  • Early Assignment: The sold put can be assigned if it goes deep in-the-money, potentially requiring the sale of the underlying at the strike price.

Managing Short Put Spreads

  • Rolling: If the underlying approaches the lower strike, consider rolling the spread to a further expiration or adjusting the strikes.
  • Hedging: Using futures or the underlying cryptocurrency, hedge the position if the market starts trending strongly downwards.

Advanced Considerations for Both Strategies

Liquidity Concerns: Trading in illiquid markets can lead to significant slippage, especially when trying to exit or adjust positions. It's essential to ensure that the chosen cryptocurrency has a sufficiently liquid options market.

Regulatory and Platform Risks: Sudden regulatory changes or platform-specific issues can introduce unexpected volatility. While these strategies are designed to profit from moderate price moves, unforeseen spikes can lead to rapid adjustments or exits, which can be challenging in illiquid markets.

Skew and Surface Analysis: The implied volatility surface can provide insights into market sentiment. A pronounced skew towards calls or puts can indicate bullish or bearish sentiment, respectively. Understanding this can help in selecting appropriate strike prices and gauging potential price moves.

Monitoring Implied vs. Historical Volatility: Comparing implied volatility (IV) to historical volatility can provide insights into whether options are relatively expensive or cheap. If IV is significantly higher than historical volatility, it might indicate that options are overpriced.

Choosing Between Strategies

Choosing the right options strategy depends on your market outlook, risk tolerance, capital availability, and desired profit potential. Each strategy has its own set of advantages and trade-offs. Ideally, you'd want to understand not just the mechanics of each strategy but also the underlying market dynamics that make one strategy preferable over another in a given situation. Here's a breakdown:

Long Call

  • Market Outlook: Bullish. You expect the underlying cryptocurrency to rise significantly.
  • Risk/Reward: Maximum risk is the premium paid. Unlimited profit potential.
  • Edge: Provides leverage, allowing for significant profits from a relatively small outlay.
  • When to Use: When you're very bullish and expect a significant upward move. Also, when implied volatility is low, making options cheaper.

Long Call Spread

  • Market Outlook: Moderately bullish. You expect the underlying cryptocurrency to rise, but not beyond a certain level.
  • Risk/Reward: Maximum risk is the net premium paid. Maximum profit is limited to the difference between the two strikes minus the net premium.
  • Edge: Reduces the cost of the long call position by selling a call at a higher strike. Also, the sold call can offset some of the time decay from the bought call.
  • When to Use: When you're bullish but want to reduce the cost of a long call or when you believe the underlying won't rise beyond a certain level. Also useful when implied volatility is high, making the sold call more valuable.

Long Call vs Long Call Spread: The spread reduces overall cost while also potentially reducing overall profit. Generally, the long call spread is used when moderately bullish, while a plain long call is used when extremely bullish.

Long Put Spread

  • Market Outlook: Moderately bearish. You expect the underlying cryptocurrency to decline, but not beyond a certain level.
  • Risk/Reward: Maximum risk is the net premium paid. Maximum profit is limited to the difference between the two strikes minus the net premium.
  • Edge: Reduces the cost of the long put position by selling a put at a lower strike. The sold put can offset some of the time decay from the bought put.
  • When to Use: When you're bearish but want to reduce the cost of a long put or when you believe the underlying won't decline beyond a certain level. Also useful when implied volatility is high, making the sold put more valuable.

Long Put

  • Market Outlook: Bearish. You expect the underlying cryptocurrency to decline significantly.
  • Risk/Reward: Maximum risk is the premium paid. Profit potential is significant but capped at the strike price minus the premium (since the price can't go below zero).
  • Edge: Provides a way to profit from declines without shorting the underlying.
  • When to Use: When you're very bearish and expect a significant downward move. Also, when implied volatility is low, making options cheaper.

Long Put Spread vs Long Put: Like their call option counterparts, these strategies differ in the amount of downside (and upside) they provide.

Test Yourself!

What should traders consider when choosing a strategy?

  • Traders should consider their market outlook, risk tolerance, capital availability, and desired profit potential. Additionally, traders should understand and consider not just the mechanics of each strategy, but also their underlying market dynamics.

  • How much profit they want to make.

  • Traders should consider the market conditions, emotional tax, and desired profit potential of a given strategy before employing them.