Option Spreads

Definition:
Option Spreads are a kind of option that will get its value from the difference between the prices of two or more assets. Spread options can be written on all sorts of financial products which include bonds, equities and currencies. This kind of position is purchased on large exchanges, but is generally traded in over-the-counter markets.
 

More Detail:
An options spread strategy involves the simultaneous buying and selling of options of the same underlying security but with different strike prices and/or expiration dates.The three most common spreads are known as:

  1. Vertical spreads
  2. Horizontal spreads (also known as Calendar Spreads)
  3. Diagonal spreads.

 

1. Vertical Spreads

A vertical spread involves the simultaneous buying and selling of multiple options of the same underlying stock, having the same expiration date but having DIFFERENT strike prices.  This strategy can be used with either all calls or all puts.

Suppose an investor is following closely ZZZ currently trading at $84.  The investor believes that the stock will begin to rally and increase in price.  The investor would utilize a Vertical Spread by (i) purchase a JUL 80 call for $600 and (ii) Write (receive credit) a JUL 90 call for $200.  Total cost to enter the position is $600 – $200 = $400.  Note that for simplicity, the brokerage fees, commissions and other fees are not mentioned.

The stock of ZZZ rises to $92 on the day of expiration in July.  Both options expire in the money, and the JUL 80 call has an intrinsic value of $1,200.  The JUL 90 call has an intrinsic value of $200.  The spread is now worth $1,200-$200 = $1,000.  Total profit at expiration = $1,000 – $400 = $600

Consider the reverse scenario; ZZZ has declined to $76.  Both options expire worthless and the investor loses the $600 to enter the call position, but collects a $200 credit for writing the put.  Total loss at expiration = $600 – $200 = $400.  The $400 is the maximum possible loss that is possible using this strategy.

 

2. Horizontal (Calendar) Spread

A horizontal spread involves the simultaneous purchase of options with a certain expiration date and the sale of the same instrument with a different expiration date.

This spread is thus also referred to as a Calendar Spread.

Suppose ZZZ is trading at $80 and believes that ZZZ will gradually rise over the next four months.

To enter a horizontal spread position, the investor would (i) Buy OCT 90 call costing $400 and write a JUL 90 call, receiving a credit of $200.

Both positions must be out of the money for the spread to be most effective.

Total cost to enter the position = $400 – $200 = $200.

Note that for simplicity, the brokerage fees, commissions and other fees are not mentioned.

 

Suppose one month later in July, ZZZ increases to $84.

The JUL 90 calls will expire worthless.

As the investor predicted, ZZZ goes on to trade at $98 in October.

The OCT 90 call expires in the money and has an intrinsic value of $800 on expiration.

Total profit from this trade is $800 – $200 = $600.

On the other hand, if the investor had picked the wrong direction of ZZZ and the stock has not risen or fell below $90, both options will expire worthless.

The investor faces a maximum loss of $200, which is the total cost to enter the initial positions.

 

3. Diagonal Spreads

A diagonal spread is utilized when an investor simultaneously buys long term calls while selling (writing) an equal number of near-month calls of the same stock with a higher strike price.

After more analysis regarding ZZZ, the investor still believes that the price will gradually increase over the next few months.

ZZZ is still trading at $80 in June.

To enter a Diagonal Spread position, the investor will (i) buy OCT 90 call for $600, write JUL 45 call for a credit of $200.

Total cost to enter the strategy = $600 – $200 = $400.

Note that for simplicity, the brokerage fees, commissions and other fees are not mentioned.

 

As predicted, ZZZ increases by $2 a month and closes at $88 on the expiration date of the long term call.

As each near-month call expires, the investor would write another call of the same strike for $200.

A total another $600 was collected as credits for the writing of 3 more calls.

At the price of $88, the OCT 80 cal expires in the money with an intrinsic value of $800.

Total profit is:

$800 (intrinsic value of OCT 80 call) + $600 (credits collected for writing the 3 calls) – $400 (initial cost to enter the positions) = $1,000

 

If the price of ZZZ had declined to $76, both options will expire worthless.

The investor would be prudent not to write additional calls since they are too far out of the money, and will not bring in a significant credit to make the position worthwhile.

The maximum loss would occur, which is the cost of the initial investment of $200.

 

Conclusion

Options strategies allow an investor to take advantage of the benefits of trading options such as the low cost to enter a position.

Many novice investors enter a position without understanding how the utilization of a spread can provide a better strategy, minimize risk and cost.

Effective use of spreads usually eliminates or greatly reduces the element of volatility, or to use it to the most of your advantage.

Option spreads are not recommended for beginner investors to jump in to right away.

Careful practice of many spreads for many different stocks is a great way to get a feel for how the options market operates.

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