Options Spreads



Options Spreads - Definition


An options position consisting of two or more different options on the same underlying stock.


Options Spreads - Introduction


Even though buying and writing call or put options alone are powerful and simple enough options trading strategies to benefit from every market condition, it is actually options spreads that produce the magic of options trading. This is why Options Spreads are frequently referred to as "Advanced Strategies" by options beginners. Options spreads are simply putting together more than one kind of option on the same underlying stock in order to produce specific payoff profiles. The effects of which range from increasing the number of possible profit directions, to presetting the maximum profit points as well as the breakeven points to specific prices as well as limiting risk.

This tutorial shall explore indepth what options spreads are in options trading as well as the mechanism and logic behind options spreading.


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What Exactly are Options Spreads?


Options spreads are strategic ways of using options by combining the basic building blocks of options trading in different strategic ways. There are six basic building blocks in options trading; Long Call, Short Call, Long Put, Short Put, Long Stock and Short Stock. Yes, options spreads can be created using options in combination with stocks as well. A common example of an options spread is the Bull Call Spread which partially offsets the price of buying at the money call options with writing out of the money call options of the same expiration month. That's right, whenever you put together more than one of the building blocks of options trading, you are creating an options spread.

Basic Building Blocks of Options Spreads
Example of How The Basic Building Blocks Can Be Combined Into Options Spreads



From the six basic building blocks of options trading is derived 26 building blocks from which countless options spreads are possible by putting together varying amount of each building block; At the money near term long call, at the money far term long call, out of the money near term long call, out of the money far term long call, in the money near term long call, in the money far term long call, At the money near term short call, at the money far term short call, out of the money near term short call, out of the money far term short call, in the money near term short call, in the money far term short call, At the money near term long put, at the money far term long put, out of the money near term long put, out of the money far term long put, in the money near term long put, in the money far term long put, At the money near term short put, at the money far term short put, out of the money near term short put, out of the money far term short put, in the money near term short put, in the money far term short put, Long Stock and Short Stock.




Purpose of Options Spreads


Options spreads serve two main purposes; Limiting Risk and Lowering Cost.

By combining the different building blocks of options trading, a position with unlimited risk, such as a naked call write, could be transformed into a position with limited risk by adding an out of the money long call option to it, transforming it into a Bear Call Spread.

Another very important function of options spreads is for lowering cost in terms of upfront debit payment as well as lowering of margin requirement for credit positions. Out of the money options could be written against at the money options that are bought in order to bring down its upfront cost. One classic example is the bull call spread where the cost of buying at the money call options is partially offset by the sale of an out of the money call option. Out of the money options could also be bought against naked write positions in order to reduce the margin requirement which reduces capital tie up. Lowering of upfront cost also results in a higher Return On Investment (ROI) on the same move made by the underlying stock, improving your trading performance.



Underlying Mechanism of Options Spreads


The reason options can be used in combination without totally cancelling each other out like futures do is due to the fact that the value of options contracts can only go down to zero but can profit without limit and that there is an extrinsic value which can be obtained by writing options, unlike futures where both the long and the short pay a margin for taking the position.

Limited Loss Potential
Due to the fact that options contracts has a limited loss potential, volatile options strategies that profit no matter if a stock goes upwards or downwards becomes possible. As options in one direction reach its loss limit, options on the other direction continue to profit in the direction of the stock , overwhelming the loss on the losing leg and resulting in a profit no matter if the underlying stock moves upwards or downwards. Such a payoff profile is only possible through options spreads due to the fact that only options have limited loss potential.

This mechanism is represented by the delta value of options which reduces as an option goes more and more out of the money. When the delta value of an option goes to zero (happening when its far out of the money), its value will no longer change with changes in the underlying stock.

Extrinsic Value
The fact that options contain extrinsic value which becomes profit for options writers form the basis of how options spreads profit in a neutral trend. By writing options at strategic strike prices and hedging them using the purchase of other options in order to remove the unlimited loss potential of short options positions, complex and precise neutral options strategies can be created whereby profit is made when the price of the underlying stock remains within a pre-determined range. One of the most famous of such complex options spreads is the Iron Condor Spread.



Classification of Options Spreads


Options spreads can be broadly classified by the relative positions of the options involved in the spread as well as by the capital nature of the options position and the type of options used.

The relative positions of the options involved is based on the strike price and expiration date of the options involved in an options spread. There are three main categories; Vertical Spreads, Horizontal Spreads and Diagonal Spreads.

Vertical Spreads
Vertical spreads are options spreads consisting of options of the same underlying asset and expiration date but different strike prices. It is so named due to the way the options involved are stacked up vertically on an options chain. Vertical spreads are usually used for lowering margin requirements or upfront capital commitment and the creation of neutral or volatile options strategies. A simple example of a vertical spread is the bull call spread. Bull Call Spread is a simple vertical spread which involves buying an at the money call option and then writing an out of the money call option in order to reduce upfront capital commitment or what most options gurus refer to as "Buying Call Options At A Discount".

Learn more about Vertical Spreads.

Horizontal Spreads
Horizontal spreads are options spreads consisting of options of the same underlying asset and strike price but different expiration dates. It is named due to the way the options involved are lined up horizontally on an options chain. Horizontal spreads are usually used for hedging against short term price fluctuations or extending the profitability of a longer term options position.

Learn more about Horizontal Spreads.

Diagonal Spreads
Diagonal Spreads are options spreads consisting of options of the same underlying asset but different strike price and expiration dates. It is named due to the way the options involved are lined up diagonally across an options chain. Diagonal spreads are used for various purposes and combine the benefits of vertical spreads and horizontal spreads.

Learn more about Diagonal Spreads.

Debit Spreads and Credit Spreads
The capital nature of an options position refers to whether you need to pay capital upfront in order to establish the position or whether you actually receive cash for putting on the position. Options spreads which you pay cash to put on are known as Debit Spreads and options spreads which gives you cash upfront are known as Credit Spreads.

Learn more about Debit and Credit Spreads.

Call Spreads and Put Spreads
When an options spread consist only of call options, it is known as a Call Spread and when an options spread consist only of Put options, it is known as a put spread. There are options strategies in all directions possible with both call spreads and put spreads and there are some complex neutral options trading strategies such as the Butterfly Spread which can be established using either call options only, making it a call spread, or put options only, making it a put spread.

Learn more about Call Spreads and Put Spreads.



Placing Options Spreads


There are two main ways of placing options spread orders; Simultaneous Order or Legging. Simultaneous order simply means that all the different options involved, known as "legs", are entered into simultaneously. This is only possible through the spread order system that most online brokers these days have where you enter all the orders involved into one page and execute them all simultaneously. This is the preferred way of placing options spreads for options trading beginners. Legging into an options spread means entering into the position one leg at a time from the most advantageous one to the least advantageous one in order to further the profitability of the position by buying each leg at a better price. Legging is a highly complex process which is most used by options trading veterans.



Advantages of Options Spreads



:: Creating Neutral and Volatile Options Strategies

:: Lowering capital commitment

:: Lowering margin requirement

:: Limit loss on unlimited loss potential positions such as the Naked Call Write



Disadvantages of Options Spreads



:: Calculation of net effect, breakeven points and resulting payoff diagram may be complex

:: More legs involved means more commissions



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Debit Spreads
Credit Spreads
What Are Call Options?
What Are Put Options?
What Are Vertical Spreads?
What Are Horizontal Spreads?
What Are Diagonal Spreads?
What Are Options Strategies?
Options Trading
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