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.

Culver prom limo ..

In The News:

An artificial intelligence-powered home security system can fire paintballs and tear gas at trespassers. The camera identifies human faces and animals.

Technology expert Kim Komando gives her tips and tricks on enhancing your user experience a smartphone and other devices you use everyday.

A new camera called NUCA uses artificial intelligence to create deepfake photos of subjects by stripping away clothing in close to real time.

The Kimberley Kube trail-ready camper has a compact but spacious design and combines luxury, functionality and ruggedness for a weekend getaway.

Stay up to date on the latest AI technology advancements and learn about the challenges and opportunities AI presents now and for the future.

Emails instructing you to reset your password for an account may be legitimate, or they may be scams. Kurt "CyberGuy" Knutsson explains.

Northrop Grumman's Manta Ray uncrewed underwater vehicle aims to revolutionize undersea missions — it glides through the ocean without human assistance.

Learn how to work Google's calendar application to streamline and organize your daily tasks from technology expert Kim Komando.

If you do not want Facebook to have automatic access to your private photos, follow our tips to protect yourself. Kurt “CyberGuy" Knutsson shows you how.

Kurt “CyberGuy" Knutsson goes into detail about Apple’s recent iOS update that allows iPhone users to instantly translate spoken language simply by using the Action Button.

Safeguarding your digital life with a reliable physical backup isn't just a precaution, it's a necessity. Kurt “CyberGuy" Knutsson provides the essential backup checklist.

Kurt “CyberGuy" Knutsson reveals how a Redditor exposed false recycling claims at their apartment, highlighting a report that only 21% of U.S. recyclables are processed.

Kurt "CyberGuy" Knutsson offers a travel toolkit featuring five technology tools to help you with booking flights and hotels for your summer vacation.

The bubble behind the clock on your iPhone can appear in different colors. Kurt "CyberGuy" Knutsson explains what each of those colors mean.

Scammers are using the power of artificial intelligence to mimic voices of people and are using the fake voices to commit crimes, like kidnappings.

Stay up to date on the latest AI technology advancements and learn about the challenges and opportunities AI presents now and for the future.

Tech guru Kurt "CyberGuy" Knutsson explains the science behind the Invisibility Shield, a 6-foot shield that makes people become invisible.

The International Olympic Committee on Friday announced plans to use AI in various Olympic aspects, including athlete identification, training and judging.

Tech guru Kurt "CyberGuy" Knutsson explains an easy trick to avoid squinting while working or surfing the web by zooming in on your personal computer.

Streaming giant Roku has recently been targeted by a pair of cyberattacks, and the company confirmed over a half million Roku accounts were compromised.

The Land Aircraft Carrier combines an all-terrain, six-wheeled vehicle with a two-seat aircraft, which features electric vertical takeoff and landing.

The European Union has sent TikTok a "request for information" on the video sharing platform's newest app, TikTok Lite, under the Digital Services Act, with the aim to clean up social media.

Stay up to date on the latest AI technology advancements and learn about the challenges and opportunities AI presents now and for the future.

The FBI is warning the public about a recent phishing scam via text that claims its targets owe money in Pennsylvania for unpaid road toll charges.

Your Apple Music settings may be revealing to your contacts what you're listening to. Kurt "CyberGuy" Knutsson explains the process to change those settings.

Option Spread Trading

Stocks & Mutual Fund