Trading risk management should always be top of mind. As options traders, we look for trades with the right combination of price and time that fit our risk profile and allow a nice profit.
Spread trading is one technique that can substantially help with your trading risk management and increase your chances of making money. Isn’t that the point of trading anyway?
How does spread trading help with trading risk management?
With spread trading, you buy and sell multiple calls or puts for the same underlying asset but with different strike prices, expiration dates, or both.
It’s a good trading risk management strategy because it removes much of the time and price risk that are inherent in markets (especially in options).
Our resident expert on spread trading, Sam DeMarco, runs our Spread Trader service and has delivered a remarkable 15% average annual return since its launch in 2016. That is better than 1.7% a month with very low risk levels versus the markets. If someone told you, “Hey, I can deliver a 1.7% return each month with very little risk,” wouldn’t you jump on board? I certainly would!
Spread trading minimizes risk and maximizes profits
Let’s look at an example of a trade to showcase how spread trading helps you manage risk.
Microsoft has been on a nice run, but Sam realizes it may pull back to support before it continues higher. Since buying a call at the wrong time could be disastrous, Sam decides to sell an upside call against a long strike to reduce his risk of being long if Microsoft’s uptrend is over.
The narrower the spread, the less risk on the total outcome. Of course, the downside is giving up profits above the short strike.
With Microsoft at $377, Sam thinks Microsoft can reach another $10 of upside in a month. The monthly $375 call would cost $930 per contract. If Sam is right about the upside, he won’t make much profit – unless the stock reaches that level quickly.
Sam realizes he can sell the $390 call at $290, receive a credit for this amount, and thus reduce his risk by 31% ($290/930). He’s still in the hunt for a move to $387 and now his breakeven point is approximately $382 versus a straight call at $386.
There are many ways to approach trading risk management, and spread trading is just one example. If learning more about it appeals to you, take advantage of our free mini course: Spread Trader Fundamentals.
