As I mentioned in the text of my inaugural column, I intend to help you, the reader, develop into a competent and successful options trader with the aid of my daily column and a question and answer format that I will respond to personally. I plan to initiate you into my own trading style, which I have honed over many years of trading both “in the pits” and off the floor in an electronic environment. I also indicated yesterday that a good motto, or battle-cry, for my style of trading might be “Staying Spread is Staying Alive." It is my opinion that a huge percentage of private traders would be using the current market prices to their advantage had they “spread off” their risk to a greater degree over the past year.

In order to become an adept spreader, you will need to begin to systematically build a solid foundation of your knowledge base. Let us begin with the basics: what is a spread and why should the competent options trader use them? A Spread is merely a position consisting of two components transacted simultaneously or in close succession where each position would profit from opposite directional price moves in the market. Each part, or “leg,” is entered into simultaneously in the hopes of either limiting risk or obtaining benefit from the change in price relationship between them. There are quite a few different kinds of spreads, and I will help you to understand some of the most important ones over the next several months, including: Vertical Spreads (the Bull Spread and the Bear Spread) and Volatility Spreads (including Straddles and Strangles, Back Spreads, Time or “Calendar” Spreads, Ratio Vertical Spreads, and finally, the highly effective Butterfly Spread).

Let’s step back for a minute. There is no question that an options trader can get the most bang for his buck by being long or short the right put or call at the right time. For example, if you are long an in-the-money call and the stock takes off, your potential profit is theoretically unlimited! Now this approach is fine under certain conditions: if you have sufficient information about market activity and volatility; time enough to follow the markets closely all day long; and lots of money to risk if you're wrong! However, I strongly contend that with a multi-leg position, a bright strategist will do better in more markets over the long haul. Trading in the options markets can be fast and furious, and when the smoke clears, it is always the disciplined, methodical trader who will end up profitable in more cases then not. This is perhaps the fundamental theme that will run through all my lessons, so mark it down now!

Before we dive in and outline various specific spreading strategies, we need to define some terms so we can locate ourselves in the spreading universe. First let’s distinguish Directional Spreads from Volatility Spreads. Once we understand the concepts behind these terms, we are on our way toward developing a powerful spreading armamentarium.

I. Directional Spreads

A trader would put on a Directional Spread when he is focusing on the underlying directional price movement (up or down). For this trader, the volatility in the market is of secondary importance, he rather wants to harness the bullish or bearish movement he foresees happening. If he goes into the position with a bullish sentiment, he wants his spread to remain bullish i.e. delta positive, regardless of any change whatsoever in market conditions. Conversely, if bearish, the trader wants his spread to remain bearish, or delta negative, “come hell or high water," e.g. if volatility, or interest rates, shift.

The first type of Directional Spread that we’ll cover will be the 1:1 Vertical Spread. This simple combination gives you a range of profitability with less risk than the outright purchase of a naked put or call. The trader has put on a Vertical Spread when he has both purchased one option and sold another where both options are of the same type (call or put) and expiration (e.g. July) but have different strike prices. (In a future lesson we will see that sometimes options traders use the term Vertical Spread to describe a delta neutral spread with multiple options where more options are bought than sold, but this is getting ahead of the game for now.)

Let’s begin with some more basic definitions: Bull Spreads and Bear Spreads. A Bull Spread is a strategy involving two or more options that will result in a profit from a rise in price of the underlying. A Bull Spread would be implemented by an investor who was bullish on the underlying but who is not bullish enough to buy a call option straight out.

Conversely, a Bear Spread is a strategy involving two or more options that will profit from a decrease in the price of the underlying. This investor is bearish about the underlying. He hopes to capitalize on what he foresees as a downward move, but is somewhat more risk averse than the outright buyer of a put.

A good rule of thumb for determining the "bias," or bullishness or bearishness of a spread is this: whether you buy the lower strike option or the higher strike option determines whether your spread is bullish or bearish. A bearish strategist would go long the higher strike, whereas a bullish investor would go long the lower strike. The rationale behind this statement will be made clear in the examples below.

Both Bull Spreads and Bear Spreads come in two “flavors," if you will. Bull Spreads can be either Call Bull Spreads or Put Bull Spreads, and Bear Spreads can be either Call Bear Spreads or Put Bear Spreads. The distinctions begin to get complicated so get out the pencil and write this stuff down!

A Call Bull Spread consists of the purchase of one call option with a lower strike price and the sale of a another call option with a higher strike price.

A Put Bull Spread consists of the sale of one put option with a higher strike price and the purchase of another put option with a lower strike price.

A Call Bear Spread consists of the sale of one call option with a lower strike price and the purchase of another call option with a higher strike price.

A Put Bear Spread consists of the purchase of one put option with a higher strike price and the sale of another put option with a lower strike price.

II. Volatility Spreads

A Volatility Spread is a slightly more complicated beast, so please pay attention and try to follow me. The trader who puts on a volatility spread is chiefly interested in the degree of volatility of the underlying, and only secondarily in the directional movement of the underlying (Volatility, for our purposes, can be defined as the measurement of price fluctuation of the underlying, i.e. the “up and down-ness” of the underlying as it deviates from its average annual price). Now the Volatility Spreader may have a bullish or bearish perspective on the market, but unlike the Directional Spreader, if he doesn’t factor in volatility, the intended direction of the spread could be reversed.

We will cover Volatility Spreads in depth in a later lesson, so I just want to stress a couple of their characteristics for now. First, volatility spreads are delta neutral, (see the glossary at www.itichicago.com/glossary.htm for this and other options terminology), that is, the total deltas of the long position equal the total number of deltas of the short position, i.e. long and short deltas cancel each other out. Second, volatility spreads are sensitive to a number of factors, including the price of the underlying, time until expiration, volatility, and finally, interest rates and dividends.

In the next lesson, we will continue to build our knowledge base by focusing on Credit and Debit Spreads.