Definition of Options Spread
An option spread is a strategy where a trader indulges in buying and selling options of equal numbers with the same class and same underlying securities but at different strike prices. The options contracts in such a strategy are usually similar but may differ in price and expiry date depending upon the type of options spread dealing with.
Explanation
It is a strategy of trading where a trader buys or sells an equal number of options contracts of the same class with the same underlying securities, but the strike price and the expiration may differ in it. The strike price and expiration date are considered according to the types of options spread dealing with. In options spread, the bull spread investor may earn a profit when the prices of the stock rise, contrary to which the bear spread investor may earn a profit when the prices of the stock decline.
How Does It Work?
Buying and selling of the same types of options are known as the options spread. The types of options can be call options or put options. A call option gives the trader a right to buy the underlying asset in the future, while the put option gives the right to sell the underlying asset in the future. To minimize the risk, the investor purchases the stock that she thinks will go up in the future and sells a cheaper out of the money option simultaneously. This not only reduces the net cost but also reduces the break-even on the trade.
Example of the Option Spread
Call spread: Here, we are taking an example of the call spread where there are different strike prices and expiration dates.
Assume trading in a call spread where the stock’s initial price is $125, and the options contract consists of 100 shares each. The component of the call spread is as follows:
- Sell call at $130 with next month’s expiration.
- Buy call at $150 with next month’s expiration.
The entry price being $1, the options contract is being sold at the strike price of $130 for $2 and bought at the strike price of $150 for $1
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The maximum profit could be earned on this deal = $1×100= $100
The call spread is 20 (buy call – sell call)
So, the maximum loss on this deal =(call spread – entry price collected) × number of shares= ($20 – $1) × 100= $1,900
Types of Options Spread
- Vertical Spread: Also known as money spread, the vertical spread has a different strike price; however, the expiration date and underlying security stay the same.
- Horizontal spread: Also known as a time spread or calendar spread, it has a different expiration date; however, the strike price and the underlying security stay the same.
- Diagonal spread: The diagonal spread is made by combining both vertical and horizontal spread. In this type of spread, the underlying security stays the same, but there is a difference in the strike price and the expiration date.
How to Buy Options Spread?
The trader can enter the option spreads by buying a stock which she thinks can give profit in the future and by selling a cheaper out of the money option at the same time within the same transaction. This will help her in reducing the cost and also minimizing the risk in the trade. The difference between the strike price and the expiration date is referred to as the spread.
When to Use Option Spread?
It can be beneficial for both the bull spread investors as well as for the bear spread investors if they are used at the right time and with accuracy. When the market shows signs that stock price will rise shortly, bull spread investors can buy and sell a cheaper out of the money option at the same time and transaction. While if it is probable that the stock price will decline shortly, the bear spread investors can sell the stocks and buy a cheaper out of the money option simultaneously. Thus, by doing so, investors can earn in the option spreads with minimal risk.
Advantages
Some of the advantages are given below:
- Low Risk: It tries to lower the risk in the investment process and help investors hedge their position.
- Investment in Underlying Asset: It enables the investor to invest in the underlying assets even when doing buying and selling on the spread position.
- More Profit: The option spread enables the investors the opportunity to earn a huge profit because of the use of options spread.
Disadvantages
Some of the disadvantages are given below:
- Need for proper knowledge: The option spread strategy is tricky, and new entrants can face losses in this type of trading if they lack proper knowledge of the market.
- Low risk to reward ratio: The amount of risk taken in options spread might not bring the corresponding amount of profit.
Conclusion – Options Spread
It is a strategy of trading where a trader does the process of buying and selling an equal number of options of the same class and with the same underlying security, but the expiration date and strike price could differ depending on the strategy type. There are three types of options spread, and each has varying features. If used wisely, optimum profits can be achieved through this strategy.
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