Part three in : The hidden problems for not experienced option traders
A short repetition : The first part showed behind the spread : Long call , short future and the second part pointed out the call credit spread. We speak here about a four leg strategy. In any option trading strategy with so many legs, we have to analyze each leg very carefully and we have to know our traded market very well.
Why did I start this little, open showed analyses of this special strategy ?
Here the reason : A friend of mine wrote me this PM : ""Lets assume the Nifty goes up. The sold call gains more than the bought call, and the sold future loses too. Now the loss is more, than before selling the future. If the Nifty goes down, then the position is back in profit. Isn't it much simpler to close out the bought call and buy a put instead?""
You may remember, that I wrote in part one about the strategy : ""Sounds easy, but has a few details which can become nasty !"" When you read this PM, he was thinking about the nasty hidden problem in this strategy which could more likely happen, when traded in an other time frame as it could happen, in the short time frame it was created for. The short time frame was in a certain way a protection, that this not should happen. Implemented in a longer time frame, the possibility that this could happen is more likely there. As trading is married with possibility and probability, we have to think in the way it is done in this PM.
If it gets to complicated now, lets recap : ""If nifty goes up, the sold call gains more than the bought call ""
This could likely happen, when the call credit spread is to big ( Strike prices are to far away from each other ) or the bid ask price in the spread is far to big, as this likely happens in nifty option pricing. Also let us assume, that the sold call is deep in the money and the bought call is otm. In that case, the sold call would act different than the bought call. The itm call would lose much more than the otm call. This could led to a dis balance in the call credit spread by it self and loss could occur as mentioned in the PM. In that situation ( Longer time frame, big range between the options and big bid ask price ), the loss even could occur in the whole four leg strategy. Not to significant, but it could.
If I under such circumstances then ask the question : ""Isn't it much simpler to close out the bought call and buy a put instead? "" , the answer can be yes. But I wrote ; Can be and not must be ! Why ? Even than : It also could be running from one trouble in to the other, when after buying the put and selling the call the market has changed his mind again and likes to go up and so on. So : Can be and not must be !
As you should create option strategy scenarios with the mentioned points and thoughts in part one, two and three, you should likely not get in much trouble.
If you are not able, to create such fine tuned stuff, then let it be and use the mentioned way for example from AW10 to trade simple credit spreads in a more or less secure way. As there is anyway no 100% sure in trading, you will have to take a risk when ever entering any trade. This risk has to look like that :
""A well disciplined and rule following cash management could never face a risk which could be sudden. It always results into a calculated well defined risk. Once a risk/reward ratio is predefined and determined, result and risk would always be minimal. As in most incidences, loss in profits rather than in capital.""
With this post, I will end the subject and wish you good success.
I hope, you had an eye opener about what option trading really is.
Take care
DanPickUp
