One Relatively Simple Way To Take Your Options Game To The Next Level
We’ve covered some of the basic options strategies out there before. In the past, we’ve focused on how traders can buy calls, sell covered calls, buy puts, or sell puts.
We’ve also covered why some basic assumptions investors make about options are not always correct. (That they’re risky or complicated, for example.) We’ve even delved into some intricacies of these strategies and how traders can maximize their chances for success.
The truth is, there are many options strategies out there. Some are riskier (or more complicated) than others. So, today, let’s move beyond the basics. We’ll discuss an options strategy that’s a little more complex (but not too complicated).
It essentially involves taking two option positions on the same stock. This is known as a “spread” trade. And as you’ll see, it can offer tremendous benefits depending on its implementation.
How Spread Trades Work
We’ve discussed the process of writing a covered call before. As you may remember, this involves selling an option on a stock you currently hold in your portfolio. A spread is similar to a covered call, except it involves covering an option instead of the underlying stock.
You might utilize this strategy if you feel a stock will move in one direction but believe the gains will be limited.
To execute a spread trade, you buy an option at one strike price and then sell an option at a strike price farther out of the money. Both contracts should expire in the same month.
Since this type of trade involves the sale of an option, the trader will receive initial income from this transaction. The income received will not be enough to offset the cost of buying the first option, but it will lower the overall cost of the trade. However, in exchange for this lower transaction cost, the investor will forfeit any gains they would have earned above a certain level.
To gain a better understanding of how a spread trade works, let’s take a look at an example…
Let’s suppose shares of XYZ are trading at $100, and you have no current position in the stock. You feel that XYZ will likely trade above $105 but will not climb higher than $110 by a certain date.
Let’s assume that an XYZ 105 call option costs $3. Meanwhile, the XYZ 110 calls are selling for $1. To maximize the profit potential from this scenario, you might purchase a spread. To do this, you would buy the XYZ 105 call for $3 and sell the XYZ 110 call for $1. The net result of these two transactions would be a debit of $2. ($3 paid to purchase one option – $1 received for the sale of the other option.)
This strategy lowers the amount you have at risk to $2. But it also limits your upside potential to $3. You can see how this works in the diagram below. In this example, the market is not predicting much volatility in XYZ, as reflected by the low option costs.
There are a few different ways to use spreads. This is just one example. (Stay tuned, and we will cover more in future articles.)
For example, if you believe a stock will move to a specific price (but not during a defined period), you might use a calendar spread.
To execute this trade, you buy an option (usually out-of-the-money) with an expiration date later in the year. Then, you simultaneously sell an option set to expire closer to the present. The desired result is simple. You want the option sold with the closer expiration date to expire worthless but for the stock to come close to its strike price. You keep the option premium from this sale and use the proceeds to offset the other option’s cost.
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