Tailor Your Trade with Spreads

Gary Delaney

The Options Industry CouncilOptions can serve as some of the bet income generating vehicles for investors and trading options is not as complicated as it might seem said Gary Delaney of The Options Industry Council. Here, he provides you with a number of income generating option strategies.

When investors or hedgers first look at options, they - rightly - look at them in the simplest way. They look at buying and selling calls or puts, the four basic strategies. But options offer more permutations than is the case when you simply buy or sell an underlying security. With options you can trade in-, at-, or out-of-the-money. You can combine long and short positions. You can trade them with different expiration dates.  In short, investors can creatively manage risk and generate income with exchange-listed options.

Relatively straightforward combinations of options can, for example, enable the investor to generate  extra income  from stocks or ETFs they own (covered call); to buy  protection for an underlying position (protective put); lower the cost of downside protection (collar); to participate in anticipated volatility regardless of direction  (long straddle), or to trade directionally with less capital at risk (vertical spread).

The use of a spread enables the purchaser to reduce the cost of the position, while also more precisely defining the outcome.   Let's look at a bull call spread example with the underlying stock at $100. The investor believes that the stock will rise 10%. So the investor buys a 100 strike call option and sells a 110 strike call. The underlying security is the same, the maturity is the same. Only the strike price is different.

If the investor's view on the market is correct, she will be able to buy the security at $100. She will be able to participate in any up move until $110, where her gain is capped because she has sold the 110 call. If the investor is wrong and the price of the underlying falls, then the net premium paid (the cost of the long call less the income from the call sold) is the most that can be lost.

Spreads are popular because they will reduce the cost of the option position. They are often the preferred 'first trading tool' of beginner traders because there can be less risk than buying stocks or options outright.

Vertical, Horizontal and Diagonal Spreads.

Here's a simple way to remember a vertical, horizontal and diagonal spread.

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In a vertical spread we are looking at two options with different strike prices - just like the vertical price axis in the chart. For a horizontal spread we are looking at two options with different expirations. Just like the horizontal time axis above. For a diagonal spread it's a mixture of the two.

A vertical spread focuses on price movement using options that expire at the same time but with different exercise prices. A horizontal spread focuses on time decay and uses options with the same strike but different expirations.  A diagonal spread focuses on price movement and time decay and uses options with different exercise prices and different expirations.

Leverage

It's interesting to compare buying the investment outright, buying a call or buying a call spread. Look at a hypothetical investment in stock XYZ, below. This example does not include fees or commissions.

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The 60-70 call spread involves buying the 60 call at $5.50 and selling the 70 call at $2. Net cost: $3.50.  The investor's forecast is XYZ will rise to, but not exceed $70, because the potential profit is capped at $70.

In the example, if the investor buys the stock at $63 and it rises to $70, he will make a $7 profit. He will continue to make a profit if XYZ stock rises further. This needs to be balanced against the fact that he has paid for the stock in full. His percentage return on investment is 11%.

If he buys the 60 call and the stock rises, then his break-even point is $60 + $5.50 = $65.50. If the stock rises to $70 at expiration he will make $70 - 60 - $5.50 = $4.50. If the stock rises above $70 before expiration his profit will rise further. His percentage return on investment is 81% with the stock at $70.

If he buys the 60-70 call spread for a net cost of $3.50, then his break-even price is $63.50. If the price rises to $70, his profit will be $70 -$60 -$3.50 = $6.50. He will not participate in any gains above $70, as he sold a $70 call. His percentage return on investment is 185%.

Bull Call Spread Diagram 

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Debit and Credit Spreads

If an investor is bullish on a stock, but finds the cost of buying the stock or option too pricey, then spreads may provide a solution. The example of the 60-70 bull call spread quoted above is a debit spread. It costs you money because the call you are purchasing has a higher value than the call you are selling.

An alternative is to build a credit spread with put options. A bull put spread involves being short a put option and long another put option with the same expiration but with a lower strike. The short put generates premium income or credit. The long put mitigates assignment risk and gives protection in the case of a sharp fall in the price of the stock. Because of the relationship between the two strike prices, the investor will always receive a credit when initiating this position. This strategy demonstrates limited risk and reward potential. The most this bull put spread can earn is the net premium received at the outset, which is likeliest if the stock price stays steady or rises. If the forecast is wrong and the stock declines instead, the strategy leaves the investor with either a lower profit or a loss. The maximum loss is capped by the long put.

Comparing the bull put spread to the bull call spread, the profit/loss payoff profiles are exactly the same, once adjusted for the net cost of carry-the net cost of holding a position, including the cost of finance. The main difference is the timing of the cash flows and the potential for early assignment. The bull call spread requires a known initial outlay for an unknown eventual return. The bull put spread produces a known initial cash inflow in exchange for a possible outlay later on.  For more information, see bull call spread and bull put spread.

For more information on the value and importance of the listed options markets, plus a comprehensive listing of OIC commissioned studies, please visit www.OptionsEducation.com.

For more information on OCC, look at the fact sheet.

By Gary Delaney of The Options Industry Council



About OIC:
The Options Industry Council (OIC) is an educational organization funded by OCC, the world's largest equity derivatives clearing organization, and the U.S. options exchanges. The mission of OIC is to increase awareness, understanding and responsible use of exchange-listed options among a global audience of investors, including individuals, financial advisors and institutional managers, by providing independent and unbiased education combined with practical expertise.  Learn more about OIC at www.OptionsEducation.org.

Disclaimers:
Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. C2016 The Options Industry Council. All rights reserved.