Today’s newsletter is by PyQuant News partner, QuantInsti. All the concepts covered in this issue are taken from the Quantra course on Systematic Options Trading. You can preview the course by clicking on the free preview button and going to Section 23 and Unit 11 of the course.

Most beginner options traders buy or sell single options in the hope of catching a big move in the underlying. This type of directional bet misses the whole point of options: defining risk before the trade.

By combining different options contracts, traders can get exposure to volatility, time decay, and other “non-linear” payoffs.

In today’s guest newsletter, we’ll discuss two of the most popular strategies: the bull call spread and the bear put spread.

These strategies are designed to navigate both bullish and bearish market scenarios.

Let’s go!

How to trade the most popular options strategies

Spread trading is a strategy where you buy and sell related contracts at the same time to profit from price differences when you have a particular view on a stock's direction. Two common types are bull call spreads (expecting a stock to go up) and bear put spreads (anticipating a stock to go down).

These strategies help manage risk while aiming for profits.

Define and build a bull call spread

A bull call spread is used when you have a bullish outlook on the underlying asset. This strategy involves buying one call option and simultaneously selling another call option on the same underlying asset but with different strike prices.

1. Long Call Option: Purchasing an at-the-money (ATM) or slightly out-of-the-money (OTM) call option. This allows you to profit if the underlying asset's price rises.
2. Short Call Option: Simultaneously, sell a call option with a higher strike price than the one you bought. The sale of the higher strike call option generates income, which helps offset the cost of the long call option.

A bull call spread benefits from a moderate upward price movement in the underlying asset while simultaneously limiting the cost of establishing the bullish position.

Define and build a bear put spread

A bear put spread can be used when you have a bearish outlook on an underlying asset. It involves buying one put option while selling another put option on the same underlying asset, both with different strike prices. The key components of a bear put spread include:

1. Long Put Option: Purchasing an at-the-money (ATM) or slightly in-the-money (ITM) put option. This allows you to profit if the underlying asset's price decreases.
2. Short Put Option: Simultaneously, sell a put option with a lower strike price than the one you bought. The sale of the lower strike put option generates income, which helps offset the cost of the long put option.

The primary objective of a bear put spread is to benefit from a moderate downward price movement in the underlying asset while reducing the upfront cost and risk associated with establishing a bearish position.

This strategy is useful when you expect the asset's price to decline but want to control the cost and limit potential losses compared to solely buying a single put option.

Trading the strategies systematically

Systematic options trading involves applying predefined strategies and rules consistently. It enables disciplined decision-making and reduces emotional trading, which can lead to costly errors.

Also, when trading systematically, the strategies can be automated, allowing better market monitoring and execution, even when you are not actively engaged.

It also offers scalability, as systematic models can handle large volumes of trades efficiently.

Defining the entry and exit rules

Let’s create a long-short spread trading strategy which deploys a bull call or a bear put spread based on the bullish/bearish signals generated using indicators.

Entry:

• If the 20-period simple moving average (SMA) is greater than the 50-period SMA and the ADX value is greater than 20, then we will generate a signal as 1.
• If the 20-period SMA is less than the 50-period SMA and the ADX value is greater than 20, then we will generate a signal as -1.

Exit:

• We will exit the trade if the take-profit or stop-loss levels are hit.
• The other condition for exit can be the difference in the value of the signal and current position. For example, if the current position is 1 and the signal is -1, we will exit the position.

In the above strategy, we have used the moving average to identify the direction of the trend and ADX indicator to determine the strength of the trend.

The indicator values such as 20-SMA and 50-SMA crossover and ADX values greater than 20 are taken for illustration purposes only. You can modify the same as per your strategy.

Next steps

The strategy discussed above has been covered in detail along with the Python code in the Systematic Options Trading course of Quantra.

You can preview the concepts taught in this course by clicking on the free preview button and going to Section 23 and Unit 11 of the course.