Spread options strategies are popular among traders who want to reduce the risks associated with trading in the financial markets. These strategies involve buying and selling multiple options contracts simultaneously to limit losses while still being able to profit from the market.
Is it time to spice up your investing game and try spread options strategies? If yes, then you are at the right place! This article will explain spread option strategies and how to use them.
Spread Option Strategies: What's and How's
A spread options strategy is a type of trading strategy that includes buying and selling two or more options on the same underlying asset at the same time. The idea behind the strategy is to limit potential losses while still being able to generate a profit.
Many spread options strategies include the vertical, horizontal, and diagonal spread.
Vertical spread
In a vertical spread, an investor buys and sells two options of the same type (both call options or put options) but at different strike prices. The goal is to limit potential losses by capping the potential profit while still taking advantage of changes in the underlying asset's price.
Horizontal spread
In a horizontal spread, an investor buys and sells two options of the same type but with different expiration dates. The strategy is used when the investor expects little or no change in the underlying asset's price.
Diagonal spread
In a diagonal spread, an investor buys and sells two options of different types with different strike prices and expiration dates. This strategy can be used to take advantage of both bullish and bearish market conditions.
Spread Options Strategies
Bull Call spread
A Bull Call spread strategy is a situation where the trader buys a call option with a lower strike price and, at the same time, sells a call option at a higher price on the same underlying asset.
The idea behind this strategy is that the investor believes the underlying asset will increase in price over time and wants to take advantage of that increase without taking on too much risk.
How does the Bull Call spread work?
The Bull Call spread works by limiting the potential gains and losses of the investor. If the underlying asset does increase in price as expected, the investor can benefit from the difference between the strike prices.
The maximum potential profit is limited to the difference between the two strike prices, less the premium paid for the long call option.
Example of a Bull Call spread
Let's say an investor is bullish on the stock of XYZ Corporation, which is currently trading at $50 per share.
The investor decides to implement a bull call spread by buying a call option with a strike price of $45 for a premium of $3 per share (the long call) and simultaneously selling your call option with a strike price of $55 for a premium of $1 per share (the short call).
If the stock of XYZ Corporation rises to $60 per share by the options' expiration date, the investor can benefit from the difference between the two strike prices, which is $10 per share.
However, the investor will have to subtract the premium paid for the long call option, which was $3 per share. Therefore, the investor's maximum potential profit would be $7 per share.
On the other hand, if the stock of XYZ Corporation does not increase in price as expected and instead falls to $45 per share, the investor can still benefit from the premium received for selling the short call option, which was $1 per share.
Additionally, the maximum potential loss is limited to the premium paid for the long call option, which was $3 per share.
Bear Put spread
The Bear Put Spread option strategy is a scheme that involves buying a put option and simultaneously selling another put option with a lower strike price.
This strategy is used by investors who are bearish on the market and want to protect their portfolios against a potential falling trend.
How does the Bear Put spread work?
The Bear Put Spread strategy involves two different options contracts. The first is to purchase a put option at a specific strike price, and the second is to sell a put option with a lower strike price. The option's strike price is the exact price at which the contract can be exercised.
The put option buyer can sell the underlying asset at the strike price. In contrast, the seller of the put option is obligated to buy the underlying asset at the strike price if the buyer applies the option.
The key advantage of this strategy is that it limits the investor's potential losses while still allowing them to benefit from a downward move in the market.
The maximum loss of this strategy is the net premium paid for the two options. In contrast, the maximum profit is the calculated difference between the strike prices minus the net premium paid.
Example of a Bear Put spread
Imagine a situation where investors believe a stock is overvalued and may experience a price decline. Then he decides to implement the Bear Put Spread strategy by buying a put option with a strike price of $50 and selling a put option with a strike price of $40.
The investor pays a premium of $3 for the $50 put option and receives a premium of $1 for the $40 put option, resulting in a net premium paid of $2. If the stock price falls to $30 at expiration, the investor would have a profit of $8, which is the difference between the two strike prices ($50 - $40) less the net premium paid ($2).
Butterfly spread
A Butterfly spread is a three-legged option strategy that involves buying one call option with a lower strike price, selling two call options with a middle strike price, and buying one call option with a higher strike price.
The strike price of the two sold call options is the same, and the distance between the strike prices of the options is equal. The same can be done with put options.
The profit potential of a Butterfly spread is limited, but so is the risk. Traders get the maximum profit if the underlying asset's price trades at the middle strike price at expiration. On the other hand, the maximum loss is limited to the cost of entering into the trade.
How does the Butterfly spread work?
As we mentioned, the Butterfly spread strategy works by selling two options with a middle strike price and buying one with a lower strike price and one with a higher strike price.
This creates a "body" and two "wings," hence the name "Butterfly." The two sold options create the "body", and the bought options create the "wings". The "body" generates the maximum profit, while the "wings" limit the risk.
For example, suppose an investor is bullish on a stock but expects it to trade in a narrow range for a specific period. In that case, they can use a Butterfly spread strategy to profit from the low volatility.
They can buy one call option with a lower strike price, sell two call options with a middle strike price, and buy one with a higher strike price. Consequently, the distance between the middle strike price and the lower and higher strike prices should be equal.
However, if the stock price moves beyond the middle strike price range, the Butterfly spread's profit potential is limited, and the maximum loss is limited to the cost of entering the trade.
Example of a Butterfly spread
For example, suppose an options trader believes that a particular stock will likely trade within a narrow range over the next few weeks.
They could implement a Butterfly spread strategy by buying one call option with a strike price of $50, selling two call options with a strike price of $55, and buying another with a strike price of $60. This creates a "butterfly" shape on a graph of potential profits and losses.
If the stock price remains between $55 and $60 at expiration, the trader can realize a maximum profit equal to the difference between the $55 and $50 strike prices minus the cost of the options contracts. The trader will realize a loss if the stock price moves outside this range.
Iron Condor spread
The next on our list of the best spread options strategies is the Iron Condor Spread. It involves the sale of two vertical spreads where the trader sells a call spread and a put spread with the same expiration date.
This strategy is designed to profit from a range-bound market, where the underlying asset's price remains within a particular range. This non-directional strategy can be used when the market is expected to be relatively stable.
How does the Iron Condor spread work?
First, the trader must identify a range of prices in which the underlying stock or index is expected to trade during the life of the options. The range is usually defined by two outer strike prices, one for the put spread and one for the call spread, and two inner strike prices closer to the underlying market price.
Then, the trader sells one out-of-the-money put option at the lower strike price and simultaneously one out-of-the-money call option at the higher strike price.
To limit the risk, the trader also buys a put option at an even lower strike price and one call option at an even higher strike price. These options act as a protective "buffer" or "wings" to the Iron Condor.
The trader profits if the underlying stock or index remains within the range of the two inner strike prices at expiration. In this case, the options sold expire worthless, and the trader keeps the premium received from selling them. The trader could lose if the stock or index moves outside this range.
The maximum profit for an Iron Condor is the net premium received from selling the two credit spreads. In contrast, the maximum loss is the difference between the inner and outer strike prices, less the net premium received.
Example of an Iron Condor spread
Speaking hypothetically, let's imagine that a trader believes a stock will remain range-bound in the next few weeks. In this case, traders could use an Iron Condor strategy to profit from the lack of movement. To do this, the trader would sell an out-of-the-money call spread and an out-of-the-money put spread.
For instance, they could sell a call option at a strike price of $120 and simultaneously a call option at a higher price of $125. Likewise, they could sell a put option at a strike price of $100 and simultaneously sell a put option at a lower price of $95.
The trader earns the maximum profit if the stock price remains between $100 and $120 at expiration. However, the trader incurs losses if the stock price moves outside this range.
Consequently, The Iron Condor strategy will allow the trader to limit their maximum loss and potential profit, making it a useful tool for risk management.
Calendar spread
The Calendar spread strategy is a popular options trading strategy that involves the simultaneous purchase and sale of two options contracts with the same strike price but different expiration dates. This strategy is also called the Time spread or Horizontal spread strategy.
How does the Calendar spread work?
The Calendar spread options strategy implies when the trader buys and sells two options contracts with the same underlying security and strike price but with different expiration dates.
The basic idea behind this strategy is that the near-term option will lose value faster than the longer-term option, and prices will widen between the two options.
The goal is to benefit from the increase in value of the longer-term option and the decrease in the near-term option, making a profit on the difference in premiums.
One of the advantages of the calendar spread options strategy is that it has a low-risk profile, as the sale of the near-term option partially offsets the options' cost. It is also a relatively straightforward strategy to implement.
However, this strategy requires careful attention to timing, as it can be sensitive to market changes and the effects of implied volatility.
Example of Calendar spread
Suppose that XYZ Company's stock price will remain relatively stable over the next few months but will likely increase significantly.
Then, you decide to execute a Calendar spread approach by buying a call option with a strike price of $50 and an expiration date of six months from now. At the same time, selling a call option with the same strike price of $50 and an expiration date of one month from now. The premium received from the sale of the near-term option will help offset the cost of purchasing the longer-term option.
If the stock price of XYZ Company remains relatively stable over the next month, the near-term option will expire worthless, and you will keep the premium received from the sale of the option.
Meanwhile, the longer-term option will retain much of its value, providing a potential profit opportunity if the stock price increases.
However, if the stock price of XYZ Company drops significantly over the next month, you may incur a loss, as the value of the longer-term option may also decrease.
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Conclusion
In a few words, spread options strategies offer a simple yet effective way to manage risk and increase profits in the world of options trading.
Whether you're an experienced trader or just starting, these strategies can help you capitalize on market trends and avoid potential losses. With their versatility and adaptability, spread options are a valuable tool in any trader's arsenal.
So, don't be afraid to spread your wings and try these clever strategies – you might just be surprised by the results!