Spread Trading: A Topic for Beginners

Do Not Trade Options Without Knowing About Spreads

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When I look at option books or options education sites on the Internet, I am always amazed when two topics are reserved for "advanced lessons." Those topics are 

The sooner that a trader recognizes the importance of understanding both subjects, the sooner that trader has a realistic chance of making money as an options trader. "Realistic chance"? Yes. Trading is a job that requires skill and the ability to pull the trigger and put into practice the lessons learned.

Unless you want to be a buy and hold investor who buys index funds (please do not waste your money by buying mutual funds. Those funds charge too much in management fees and the vast majority cannot outperform low-fee index funds), then the more you understand about these principles, the better you can manage your own money. It is not necessary to become a full-time trader to take advantage of an options education.

The rationale behind these thoughts.

Spreads: A simple method for reducing risk (hedging) when trading

The following quote from a typical beginner's option course taught at a community college is way off the mark and in my opinion causes much more harm than good.

I do not want to embarrass anyone at the college and prefer not to mention the source of the quote. However, anyone who knows how to use Google can discover that source. It comes from the Elgin Community College syllabus.

"Get ready to learn about your first basic option strategy—the long call. When you finish this lesson, you'll know the best way to profit when you think a stock price is about to go up. You'll also understand which option to buy depending on how bullish you are about that price movement."

That quote represents a description of a 2-hour lesson  (#6 of 12 total).

That lesson -- all by itself explains why most options traders lose money and quit. Buying options is a very difficult way to earn money.

This lesson fills two hours and comes in the middle of an introduction to options course. By lesson #6, the student should be learning far more material -- information that helps the student learn something about using options effectively.

Buying options is an easy-to-understand process. The most difficult part of that strategy is recognizing that it is never easy to "profit when you think the stock price is going up." For that reason, it is a very inappropriate strategy for students who are first learning about options.

Why do I believe that?

  • Most professional stock-pickers (managers of pension funds, mutual funds, etc.) cannot consistently outperform the market averages. If the pros cannot do better than index funds, why would any trader believe that he has the skills to do so?
  • The idea of "how bullish you are" is not the most important factor when investing via the options market. [Yes, I encourage anyone who makes directional trades to have a price target, and thus a profit target in mind, but that does not change the fact that predicting a specific price level is beyond the ability of most. If an investor cannot guess correctly which stocks are moving higher, then it surely doesn't matter how much he/she expects the stock price to change. Thus, this is not the major factor that a winning trader uses to select which call option to buy. In fact, thinking this way it is a trap for the novice. It represents the wrong mindset. For example, when a stock is trading near $70 and the novice options trader "expects' it to move to $80, that novice typically buys call options with an $80 strike price. That is just terribly wrong-headed. It is far better to buy the $75 or (better yet) the $70 call option. Why? Suppose you are "right' but not 100%? Suppose the stock moves from $70 to $74 or $78. Either is a move where the trader deserves to earn a profit. If you buy the wrong options (80's), and especially if you do not choose an appropriate time to exit the trade, you would probably lose money. There is far more to this discussion, but for now, it is important to understand that the material taught in such a course (assuming that the course resembles the syllabus) does more harm than good.
  • It is important to understand the concept of buying (and selling) options because it helps traders understand how options are valued and how much one should or should not pay for them. It also helps a trader understand when it is a good time to buy or sell options. The trader who learns to buy and sell spreads instead of individual options has a far better chance of earning money over the longer term.