Option spreads, the best way to handle consolidating market

Option spreads are the best ways to handle the consolidation in market.

Markets tend to consolidate for long periods of time. Trading in options becomes a little difficult during such periods because of two key reasons.

Options have a premium which is directly related to the passage of time. As time progresses, option premiums get a negative impact. It becomes more of an issue when the market is consolidating — every move that comes along may take a little while, so, later the target is achieved, smaller is the profit.

This is not a bad thing. During consolidation, we do expect a lack of movement. Option premiums are positively aligned with expected volatility as well. So, if the expected volatility is low, the same option premium with the same expiry and the same underlying price will be valued at a much lower rate.

Option spreads are the best ways to handle this problem and for that, we have to understand what option spreads are. Simply put, an option spread = buy + sell the same kind of options (call / put) with different strikes (sometimes of different expiries)

Option buyers worried about hitting the target in a timely fashion can relax with the help of option spreads. The problem for option buyers is that they lose a lot of time value while waiting to hit their target. This passage of time negatively impacts the option buyer. However, if one has an option spread, one can be a buyer in one and a seller in another option. This will help reduce the impact of the passage of time.

Well, simply buy call or put based on the bullish or the bearish view like you normally do. Simply add a sell position by selling a higher strike call / lower strike put.

Bullish spread = buy call + sell higher strike call (strike closer to target)

Bearish spread = buy put + sell lower strike put (strike closer to target)

Sellers will have a very small premium to justify returns on the margin paid. The premium will be low because during consolidation there will always be an expectation of lower volatility and the resultant lower premium.

If one creates a spread, they will buy a cheaper option against a sold option. This will immediately turn their trade-risk profile from unlimited to limited risk. This reduces the margin requirement. A lower margin requirement will justify returns even on the net premium received.

With sell call,  buy higher strike call (Cheaper)

With sell put, buy lower strike put (Cheaper)

For option buyers as well as sellers, spreads do reduce the profit but they improve profitability for option writers while saving time-related losses for option buyers.

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