Option Spreads: Tips And Things To Consider

Now that we’ve covered the basics of option spreads, here are some tips on how to use them. In this section, we'll focus on the use of orders, liquidity and some margin-related matters. 

The use of spread orders

As a rule, spread trades should be established using a spread order – and leaving legging into the spread (placing one leg at a time) to the pros. The possibility of having the market move against you while trying to leg in makes using spread orders imperative. But what type of spread orders should you use? In general, you should always work a spread order using a limit price to assure you get the desired price that will make the spread work out according to plan. Because there’s a limited profit potential in many spreads, it’s essential to get filled correctly – or not get filled at all. Limit orders serve this purpose well. (For related reading, see: Introduction to Order Types.)

In today's online trading environment, simple spreads can be placed with limit orders and filled without too much trouble. Of course, it’s important to make sure the option strikes comprising the spread have enough liquidity, measured in open interest and daily volume. The options should have at least a few hundred options traded (on average) daily with at least as much open interest if you are doing spreads that may require adjustments or the removal of the spread if it gets into trouble. 

If you simply plan to hold a debit spread (buying spreads) until expiration, then liquidity is not as important. However, be aware that the more liquid the market, the better the pricing. With little liquidity, the market makers tend to widen the bid-ask spreads, making it harder to reach your profit objectives. If you’re unsure about what size the bid-ask should be, look at the option prices for a few days to get an idea of how they are being priced. You can also compare the bid-ask spreads across stocks of similar prices to evaluate how wide the market is. (See also: The Basics of the Bid-Ask Spread.)

Margin requirements

In most of the spreads presented in this tutorial, margin requirements are straightforward. For example, if you were to sell a vertical credit spread like the MSFT call credit spread example using the strikes that are five points apart, the margin on the account would be the size of the spread minus the premium collected. In this case, since we collected $120 in premium, the margin requirement would be $500-$120=$380. If we were to retain the entire premium collected as profit, the rate of profit on the required (and maximum margin) would be 24% (abstracting from commissions). (For related reading, see: Margin Requirements.)

For debit spreads, the capital required to open the position is always the cost of buying the spread. All debit spreads are strategies that are bought, so there must be enough capital in the account to pay for the spread. 

For diagonal spreads, the margin story is a bit trickier. If the spread is established in a futures options market, a margin system known as SPAN applies. SPAN margin offers the advantage of having the nearby short option in a diagonal call or put credit spread looked at as a covered option. In most equity options brokerage accounts, the short leg across months is margined as a naked option, which can significantly impact overall performance due to the extra margin that is required to trade the strategy. 

Finally, when applying horizontal and diagonal spreads to futures options, you may be trading two underlying contracts. For example, an S&P 500 futures options June-September diagonal put spread would have the June trading on the June futures and the September option trading on the September futures contract. It is not a big issue really, but something to be aware of if you decide to explore options on futures as an additional arena for applying options spreads. (See also: S&P 500 Options on Futures: Profiting from Time-Value Decay.)