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Page last updated Tuesday, 08 December 2009
Derivatives Bulletin - Issue 49 : January 2010
The Channel Spread
By Danny Moss & Owen Beattie
Firstly, what is a Spread?
In reference to options, a ‘spread’ is a stand alone strategy which involves more then one series of options. All but the most basic of option strategies are considered ‘spreads’, as they will involve buying or selling options of different series to construct a trade which will reward a specific market event or outcome.
In this article we will explain in lay terms the structure of a Condor, or ‘Channel Spread’. This particular option spread involves a bullish spread and a bearish spread packaged together and rewards a range bound market environment.
Now, what’s a channel spread?
A channel spread is a four ‘leg’ (series) option strategy which allows the trader to profit from a stock simply trading within a range or ‘channel’ for a set period of time.
To construct a Channel Spread the trader will sell both an out of the money Call Option and a Put Option for the same expiry month while simultaneously buying a Call Option at a higher strike then our sold call and buying a Put Option with a lower strike than our sold put.
This creates a ‘profit channel’ and capped danger zones. The ideal outcome is that volatility in the stock remains low and the stock continues to trade above our sold put option and below our sold call option until the Channel expires.
Example of Channel Spread
We opened a Channel trade in October on ASX Limited (ASX) – Our chosen Channel was between $32 on the lower level and $36 on the upper level, or a channel range of around 12.5%. If the stock traded below $32 we were protected at $31 (with our bought put). If the stock traded above $36, we were protected at $37 (with our bought call).
The maximum risk on each side was $1. The credit received was on average 38 cents. This equates to a return on risk of around 38%, double that of the traditional one sided credit spread and with the same financial risk – Remember, risk is fungible.
As ASX closed at 33.32 at the end of October the Channel expired worthless and we retained the full premium for the trade. It was a winning Channel Spread.
How do I make money on this?
Due to the fact we are selling options which are closer to the money then we are buying, this strategy will be opened at a credit, meaning the investor is paid immediately.
If at the ‘expiry’ of the Channel Spread the stock is still trading within that channel the strategy simply expires and trader retains the full premium they received for opening the spread in the first place.
The best market for ‘Channelling’
The best market environment for Channel Spreading a stock is one of low volatility and a tight, consistent trading range. This market dynamic will often be witness during times of consolidation after a significant trend (such as a bullish uptrend or bearish downtrend). It is at this time the trader may wish to profit from a neutral view and a flat market.
Channel Spreads can also be utilised in conjunction with existing stock holdings as a form of additional income yield above traditional methods of stock income such as dividends and covered calls.
What can I Channel Spread?
A trader can utilise Channel Spreads to profit on most ASX/50 stocks (overlying option market liquidity depending) and the ASX/200 index itself (known as the tick code ‘XJO’).
Benefits of a Channel Spread
The largest benefit of the Channel Spread is the ‘double premium’ the spread will attract. Because we need the stock to trade within an upper and lower limit you will receive a double premium.
However, the risk of the strategy is virtually identical to most other ‘directional spreads’ such as Bull Put Spreads (credit spread) or Bear Call Spreads (Credit Spread). The reason this is the case is that the Channel Spread (like all credit spreads) will only actually lose at the expiry of the spread. At that point, if the spread is a loser, the stock will be breaching either the upper or lower limit – it can’t breach both at once!
Marginable?
Yes, a Channel Spread will be margined by the Australian Clearing House (ACH) due to the sold put and call being closer to the share price then our protective bought put and call. The margin on this strategy should remain relatively constant and depends on underlying volatility etc.