Options Spread

Updated on April 17, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is An Options Spread?

Options Spread are strategies used to trade options in the financial market and consist of the spread positions between the price of options in the same asset class with an equal number of options with a different strike price and expiration dates. The expiration date and the strike price are different, and the difference between the strike prices is the spread position.

Options-Spread

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There are individual, and combination option spreads, and Investors or traders can use these strategies at their convenience. Trading on spreads requires knowledge of the market and expertise in the functionality of the strategies. These are highly complex strategies and can result in the loss of the entire investment if the market conditions are not gauged properly.

Key Takeaways

  • Options spreads are trading methods that utilize an equal number of options with varying strike prices and expiration dates to create a spread position between options prices in the same asset class. The difference between the strike prices and the expiration date determines the spread position.
  • Horizontal, vertical, and diagonal spread are the options spread types.
  • It is the tactic used for trading, which should be distinct from spread options and derivative contracts. While the tactics assist in creating profits from the investment, they also decrease the associated risk.

Options Spread Explained

Options spread the strategies used for trading options, which should not be confused with spread options, which are derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. While the strategies help make profits from the investment, they also minimize the risk involved.

Debit and credit options spread strategies create a profit for the investor if the premium of the option sold is higher than the premium of the option bought. The investor receives credit for such a transaction while entering the spread. If this were to be the opposite, the investor would be debited while entering the spread.

When the spread is entered on debit, it is called the debit spread, whereas the spread entered in credit is called a credit spread.

Spread combinations are complex options devised using strategies aimed at reducing the risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more while trying to earn a profit.

Box spread consists of a bear put spread, and a bull call spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more refers to a trading strategy where the trader speculates a limited price appraisal of the stock. In such a trade, the risk involved is neutral; hence, the investor can enter a position while negating the risk altogether. In such a strategy, only the premium paid will be the maximum loss the investor has to bear.

To exemplify,

  • Long call – Oct 2019 – Strike 60
  • Short put – Oct 2019 – Strike 60
  • Short call – Oct 2019 – Strike 70
  • Long put – Oct 2019 – Strike 70
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Types

Given below are some common types of the financial instrument in the area of options spread strategies that are widely used for trading purpose.

Options-Spread Types

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The different kinds of option spreads can be depicted with the help of a graph, as given below. The graph clearly explains how the strike price and the date of expiry combine together to determine the type of spread. However, the trader needs to understand the combination and the details of the underlying asset so as to take maximum advantage of the price and market movements to earn profit.

These spreads are typically used to control the risk exposer due to price fluctuations and take trades that are within the risk-taking ability and financial objective of the trader. But spreads also limit the profitability of the trade. Therefore, it is to be noted that using spreads means limiting both risk and profits.

Source

How To Enter?

Entering the process of options spread trading involve buying and selling of a combination of contracts at a specific strike price and expiration dates to create a spread. Let us study the septs as given below:

  • The first step is to choose the type of option strategy that s in alignment with the investment and the condition of the market. The investor may select any of the spreads mentioned above.
  • Then comes the selection of the underlying asset. The trader ofr investor has to select the asset which may be a stock, an index, a commodity of an ETF on which they wish to trade.
  • Next, in options spread trading, the strike price and expiration dates need to be determined. The strike price is the price at which the option will be executed and the expiration date is the date till which the contract will be valid. These parameters will depend on the type of spread selected.
  • In the next step, market analysis is required, where the investor will identify the direction of the price movement, the volatility of the asset and based on that the investor will decide whether the market is bullish, bearish or neutral.
  • Next the investor will place the trade. Based on the above analysis, two separate orders will be placed and through the broker. There is some amount of brokerage fee involved in this step. The investor should clearly specify the expiration dates, and the strike prices for each order.
  • After the order is places, it is extremely important to monitor and manage the trade at regular interval. If the asset is fluctuating, then some adjustments may be made depending on the market condition. If the return objective is met or market conditions suddenly change with does not match the investor’s expectation, then it is necessary to close the position.

Therefore the above are the steps taken to trade using option spread. But it is important to have a good understanding about the process so that it can be implemented at the correct time using the most suitable strategy.

Examples

Let us understand the concept of options spread trade with the help of some suitable examples.

Example #1

The below example of a call credit spread is an options strategy that creates a profit when the value of the underlying security is expected to fall.

The initial stock price while entering a call credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ).read more is $163. Each option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more consists of 100 shares. The components of call credit spread are:

  • Sell call at $165 with expiration in the next month
  • Buy call at $180 with expiration in the next month

The entry price for the option is $1 (Sold at $165 for $2 and bought at $180 for $1)

The maximum potential profit for this options deal is:

  • = $1 x 100
  • = $100

The call spread in this scenario is 15

Hence, the maximum potential loss is:

= (Call Spread – Entry price collected) x No of shares

  • = ($15-$1) x 100
  • = $14 x 100
  • =$1,400

Example #2

The below example of a put credit options spread trade is an options strategy that creates a profit when the value of the underlying security is expected to rise.

The initial stock price while entering a put credit spread is $330. Each contract consists of 100 shares. The components of the put credit spread are:

  • Sell put at $315 with expiration in the next month.
  • Buy put at $310 with expiration in the next month.

The entry price for the option is $1.15 (Sold at $315 for $5.60 and bought at $310 for $4.45)

The maximum potential profit for this options deal is:

  • = $1.15 x 100
  • = $115

The put spread in this scenario is 5

Hence, the maximum potential loss is:

= (Put Spread – Entry price collected) x No of shares

  • = ($5-$1.15) x 100
  • = $3.85 x 100
  • =$385

Advantages

Let us identify the advantages of the concept in detail.

Disadvantages

Some disadvantages of the concept of stock options spread or any other asset are also given below.

  • Trading on option spreads requires expertise and knowledge of the market, which is a bit tricky for new entrants.
  • Just like the risk, which is minimized, the profit is also capped.
  • The risk-to-reward ratio is minimal, meaning the risk taken for the amount of profit earned is massive.

Frequently Asked Questions (FAQs)

Why are options spreads so wide?

The way market makers handle the risks associated with their option holdings and transactions is frequently the cause of the bid/ask option spread widening. Usually, market makers don’t make predictions price of the underlying stock.

Are option spreads profitable?

Debit spreads can be a winning strategy for traders who think stock prices will move in a specific direction. The asset must expire at or above the option’s strike price to maximize the benefit from a debit spread.

When to use options spread?

In many circumstances, options spreads allow traders to specify their risk. They know how much they stand to make or lose before entering the spread trade. While risk may often be determined in advance, profit potential may also be limited.

Can option spreads be adjusted?

Yes, option spreads can be adjusted to accommodate changes in market conditions. Traders might adjust by rolling the spread to a different expiration or strike price or adding or removing legs to manage risk.

This has been a guide to what is Options Spread. We explain its types along with examples, how to enter, advantages and disadvantages. You can learn more about finance from the following articles –