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> Options Guide > Spreads
and spread trading |
Spreads and Spread Trading
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Spread trading is a technique that can be used to
profit in bullish, neutral or bearish conditions.
It basically functions to limit risk at the cost
of limiting profit as well.
Spread trading is defined as opening a position
by buying and selling the same type of option (ie.
Call or Put) at the same time. For example, if you
buy a call option for stock XYZ, and sell another
call option for XYZ, you are in fact spread trading.
By buying one option and selling another, you limit
your risk, since you know the exact difference in
either the expiration date or strike price (or both)
between the two options. This difference is known
as the spread, hence the name of this spread treading
technique.
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Spread
trading is carried out by buying
an option, and selling an option
of the same type for the same stock. This
technique limits your risk, since
you know the spread between the two options. However,
profits are limited as well.
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Various
strategies can be carried out using this technique.
The main ones are vertical spreads, horizontal spreads
and diagonal spreads.
A Vertical Spread is a spread where
the 2 options (the one you bought, and the one you
sold) have the same expiration date, but differ
only in strike price. For example, if you bought
a $60 June Call option and sold a $70 June Call
option, you have created a Vertical Spread.
Let's take a look at why you would do this.
Let's assume we have a stock XYZ that's currently
priced at $50. We think the stock will rise. However,
we don't think the rise will be substantial, maybe
just a movement of $5.
We then initiate a Vertical Spread on this
stock. We Buy a $50 Call option, and Sell
a $55 Call option. Let's assume that the $50
Call has a premium of $1 (since it's just
In-The-Money), and the $55 Call has a premium
of $0.25 (since it's $5 Out-Of-The-Money).
So we pay $1 for the $50 Call, and earn $0.25
off the $55 Call, giving us a total cost of
$0.75.
Two things can happen. The stock can either
rise, as predicted, or drop below the current
price. Let's look at the 2 scenarios:
Scenario 1: The price has dropped
to $45. We have made a mistake and predicted the
wrong price movement. However, since both Calls
are Out-Of-The-Money and will expire worthless,
we don't have to do anything to Close the Position.
Our loss would be the $0.75 we spent on this spread
trading exercise.
Scenario 2: The price
has risen to $55. The $50 Call is now $5 In-The-Money
and has a premium of $6. The $55 Call is now
just In-The-Money and has a premium of $1.
We can't just wait till expiration date, because
we sold a Call that's not covered by stocks
we own (ie. a Naked Call). We therefore need
to Close our Position before expiration.
So we need to sell the $50 Call which we bought
earlier, and buy back the $55 Call that we
sold earlier. So we sell the $50 Call for
$6, and buy the $55 Call back for $1. This
transaction has earned us $5, resulting in
a nett gain of $4.25, taking into account
the $0.75 we spent earlier.
What happens if the price of the stock jumps
to $60 instead?
Here's where the - limited risk / limited
profit - expression comes in. At a current
price of $60, the $50 Call would be $10 In-The-Money
and would have a premium of $11. The $55 Call
would be $5 In-The-Money and would have a
premium of $6. Closing the position will still
give us $5, and still give us a nett gain
of $4.25.
In tabular format:
|
| Resulting Stock Price |
$45 |
$50 |
$55 |
$60 |
| Premium of $50 Call |
--- |
$1 |
$6 |
$11 |
| Premium of $55 Call |
--- |
$0.25 |
$1 |
$6 |
| Difference in Premium |
--- |
$0.75 |
$5 |
$5 |
| Initial Cost |
$0.75 |
$0.75 |
$0.75 |
$0.75 |
| Total Profit |
-$0.75 |
$0 |
$4.25 |
$4.25 |
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Once both Calls are In-The-Money, our profit
will always be limited by the difference between
the strike prices of the 2 Calls, minus the
amount we paid at the start.
As a general rule, once the stock value goes
above the lower Call (the $50 Call in this
example), we start to earn profit. And when
it goes above the higher Call (the $55 Call
in this example), we reach our maximum profit.
So why would we want to perform this Spread?
If we had just done a simple Call option, we would
have had to spend the $1 required to buy the $50
Call. In this spread trading exercise, we only had
to spend $0.75, hence the - limited risk
- expression. So you are risking less, but you will
also profit less, since any price movement beyond
the higher Call will not earn you any more profit.
Hence this strategy is suitable for moderately bullish
stocks.
This particular spread we have just performed
is known as a Bull Call Spread,
since we performed a Call Spread with a bullish
or upward-trending expectation. Similarly,
Bull Put Spreads, Bear
Call Spreads and Bear Put
Spreads are all based on the same
technique and function quite the same.
Bull Put Spreads are strategies
that are also used in a bullish market. Similar
to the Bull Call Spread, Bull Put
Spreads will earn you limited profit in an uptrending
stock. We implement Bull Put Spreads
by buying a Put Option, and by selling another Put
Option of a higher strike price. The Bear Spreads
are similar to the Bull Spreads but work in the
opposite direction. We would buy an option, then
sell an option of a lower strike price, since we
anticipate the stock price dropping.
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A Vertical
Spread is a spread where the options you
buy and sell only differ in strike price.
A Bull Call Spread is a spread
performed on a bullish stock. You
Buy a Call at a particular strike
price, and Sell a Call with
a higher strike price. Breakeven occurs
when the stock rises above the lower strike price,
and maximum profit occurs when the stock rises above
the higher strike price.
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We now look a Horizontal Spreads.
Horizontal Spreads, otherwise known as Time
Spreads or Calendar Spreads, are spreads where
the strike prices of the 2 options stay the
same, but the expiration dates differ.
To recap: Options have a Time Value associated
with them. Generally, as time progresses,
an option's premium loses value. In addition,
the closer you get to expiration date, the
faster the value drops.
This spread takes advantage of this premium
decay.
Let's look at an example. Let's say we are now in
the middle of June. We decide to perform a Horizontal
Spread on a stock. For a particular strike price,
let's say the August option has a premium of $4,
and the September option has a premium of $4.50.
To initiate a Horizontal Spread, we would
Sell the nearer option (in this case August),
and buy the further option (in this case September).
So we earn $4.00 from the sale and spend $4.50
on the purchase, netting us a $0.50 cost.
Let's fast-forward to the middle of August.
The August option is fast approaching its
expiration date, and the premium has dropped
drastically, say down to $1.50. However, the
September option still has another month's
room, and the premium is still holding steady
at $3.00.
At this point, we would close the spread position.
We buy back the August option for $1.50, and
sell the September option for $3.00. That
gives us a profit of $1.50. When we deduct
our initial cost of $0.50, we are left with
a profit of $1.00.
That is basically how a Horizontal Spread
works. The same technique can be used for
Puts as well.
A Diagonal Spread is basically
a spread where the 2 options differ in both strike
price and expiration date. As can be seen, this
spread contains a lot of variables. It is too complex
and beyond the scope of this guide.
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A Horizontal
Spread is a spread where the 2 options
differ in expiration date. You
Sell the Closer option, and Buy
the Further option. You close the position
once the Closer expiration date nears. A Diagonal
Spread is a spread where both strike
prices and expiration dates differ.
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We hope
you have enjoyed this guide, and benefited from
the simpler terms we've used to describe option
trading. Do note that throughout the guide, we have
not taken into account additional costs such as
commissions and differences in bid/ask prices. Including
these would have complicated this guide more than
we wanted. Just note that these costs exist and
will add to your costs and lower your profits.
If you want to read up on more sophisticated strategies,
check out www.optionetics.com.
If you would like to start trading options, or try
some paper trading to get a feel of what it's like
to trade options, you can visit www.optionsxpress.com.
And if you are interested in learning about Technical
Analysis
and Technical Indicators, do
visit our Technical
Analysis Guide if you have not already done
so.
If you want to link to this guide, please
click here.
Thank you!
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