What is Options Spread?
Options Spread are strategies used to trade options in the financial market and consists of the spread positions between the price of options in the same asset class with an equal number of options that have 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 Types
- Horizontal Spread – A horizontal spread is created when an option using the same underlying security with the same strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and an expiration date that is different.
- Vertical Spread – A vertical spread has a different strike price; the expiration date and the underlying security remains the same.
- Diagonal Spread – Diagonal Spread consists of options that have the same underlying security but the expiration date and the strike prices. A diagonal spread is a combination of the above mentioned horizontal and vertical spread.
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Source: Options Spread (wallstreetmojo.com)
Examples
#1 – Call Spread
A call spread consists of call options of the same underlying security that has a different strike price and expiration date.
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.
Example
The initial price of stock 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
#2 – Put Spread
Put spread consists of put optionsPut OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more of the same underlying security that has a different strike price and expiration date.
The below example of a put credit spread is an options strategy that creates a profit when the value of the underlying security is expected to rise.
Example
The initial price of stock 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
Important Points
- Debit and credit spreads create a profit for the investor if the premium of the option that is sold is higher than the premium of the option that is bought. For such a transaction, the investor receives a credit while entering the spread. Whereas 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 strategies that are devised using a combination of different strategies that are 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 the profit.
- Box spread consists of a bear put spread and 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. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.” url=”https://www.wallstreetmojo.com/bull-call-spread/”]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[/wsm-tooltip]. In such trade, the risk involved is neutral, and 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 that 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
Advantages
- It helps investors to hedge their position and limit the amount of risk exposure.
- It allows investors to invest in an underlying assetAn Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more while trading on the spread position.
- The probability of earning a profit using option spread is high while limiting the exposure to the risk in the investment.
Disadvantages
- 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 very minimal, which means the risk taken for the amount of profit to be earned massive.
Conclusion
- Options spread the strategies used for trading options, which should not be confused with spread options, which are derivative contracts. While the strategies help in making profits out of the investment, it also minimizes the risk involved in the investment.
- There are individual as well as 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 loss of the whole investment if the market conditions are not gauged properly.
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