V.13:10 (425-429): Options Spread Psychology by Steven P. Schinke, Ph.D

V.13:10 (425-429): Options Spread Psychology by Steven P. Schinke, Ph.D
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TRADING PSYCHOLOGY Options Spread Psychology by Steven P. Schinke, Ph.D.

Choosing an options spread strategy depends in part on individual psychology about market conditions. By understanding how emotions affect behavior, traders can add precision to their options spread positions.

Options spread positions are trades that involve the simultaneous purchase and sale of two or more options to exploit differences in price change between them. By initiating such a position, the trader can forecast how the market will move. Implicit in that forecast is the trader's confidence about the direction and timing of the anticipated change in option prices.

Here's an example. Mary believes the Standard & Poor's 500 index will move higher over the next two months, but her data suggests the market may not move steadily upward during that period. Rather, her information indicates that the market may fluctuate on its way higher or perhaps slide sideways for several weeks. Mary, considering how she can maximize her profits while minimizing her losses, rules out a straight long futures position because of the high required margin.

Speculating that S&P futures will not drop in the ensuing two months, Mary is nonetheless concerned about the likelihood of adverse fluctuations or the absence of positive changes in that period. Accordingly, she rejects the idea of doing a long option, given the predictable erosion of premium on options expiring at or shortly after her time projections. Based on her analyses and confidence levels, Mary looks instead at two vertical spread opportunities, a call debit spread and a put credit spread.

To implement the first spread, Mary would buy a call option with a strike price at or higher than the current S&P futures contract and concurrently sell a call option with a strike price higher than the one she sold. Despite this strategy's potential profit, it produces a debit when established. That worries Mary because she lacks confidence in the market's ability to advance sufficiently to make back the premium she paid and generate profit.

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