Option Spread Trading

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.

VERTICAL 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 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.

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.

HORIZONTAL SPREADS

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.

For more information on spread trading, visit: http://www.option-trading-guide.com/spreads.html

Steven is the webmaster of http://www.option-trading-guide.com. If you would like to learn more about Option Trading or Technical Analysis, do visit for various strategies and resources to help your stock market investments.

---

Protectionism

First let's see what protectionism is. According to Mr. Webster... Read More

I Love You, Warren Buffet

Sometime around 1980, can't remember exactly, there was a flight... Read More

No Load Mutual Funds: Boost Your Portfolios Returns

Investors who exclusively use broadly diversified, no load mutual funds... Read More

Option Trading Basics

Options trading can increase the profits you make when trading... Read More

An Old Proverb for Investing

"If you don't know where you are going, any road... Read More

Pamplona, the Wild Investment Bulls

You remember (they show it on TV every year) the... Read More

The 1% Solution

You probably know the story of Sherlock Holmes and the... Read More

Take The Time

You must take the time once a month to review... Read More

High Price/Earnings Ratios and the Stock Market: a Personal Odyssey

After some forty years of banking and investments, I retired... Read More

The Big Bad Bear

The big bad bear is stirring again. So far he... Read More

I Love To Lose Money

Well, not really. What I mean is I don't mind... Read More

What Does it Take to be a Stock Trader?

It takes a total mental commitment to the task. It... Read More

Why the Majority Fail at Stock Investing

The gleam and bright lights of Wall Street lure in... Read More

Why This Bear?

People are constantly asking me why is the stock market... Read More

The Stock Market - How Just One Question Will Tell You All You Need To Know About Your Stock Broker

Last time we looked at the real performance of the... Read More

The Stock Market Investor?s Worst Enemy

Every stock market investor faces one primal enemy. An enemy... Read More

Zero Sum Game

Most people think the stock market is a zero sum... Read More

Buy Low - Sell High

Now where have I heard that before? I know. It... Read More

Trading Stocks ?Never Forget About A Past Trade

We all know that emotions control every decision that an... Read More

Analyst Reports

When you become interested in a stock or mutual fund... Read More

Stocks & Oil, Sat Jun 18th, 2005

Both the stock market and oil prices rallied recently, which... Read More

Investment Clubs

Because you don't feel too sure about which stock or... Read More

The Seven Mistakes All Novice Traders Make and How to Correct Them

We learnt the following the hard way! If any of... Read More

Hill of Hope

Just about now everyone is confused as to which way... Read More

Do You Know What is the Single MOST Critical Mistake in Trading the Stock Market??

Well maybe that's overstating it a little, but it's certainly... Read More

Stock Loans

Hedge current portfolio positions and gain access to capital resources... Read More

You Don?t HAVE To Be Trading

As a novice trader, you'll often feel the need to... Read More

Can?t Stand The Heat

It seems that every day I turn on the TV... Read More

365/7/24

What does it take to be a stock trader? It... Read More

Dont Buy Stocks based on P/E Ratio alone

I use the P/E ratio as a secondary indicator for... Read More

Where Is The Beef?

Where is the beef? Or maybe it should be where... Read More

How to Find Value in No Load Mutual Fund Investing

What are you thinking when it comes to your no... Read More

Stuff

I continually hear from economists, talking heads, other market letter... Read More