When to Opt for an Option Spread

03/31/2011 10:40 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Options expert Dan Passarelli explains situations when traders should consider the additional benefits of an option spread, which can offer lucrative profits and defined risk.

Well, if you’re an equity trader or a futures trader and you want to get started in options, you may start by buying a call or a covered call or some simple strategies such as just buying options outright, but what about spreads? 

More traders get into spreads after they get a little more sophisticated in this business. Our guest today is Dan Passarelli. He’s an options expert. So, Dan, talk about getting started in spread strategies. First of all, what’s the benefit of doing a spread in options?

Generally, with spreads, you kind of optimize your risk/reward ratio. 

You can—depending on the type of spread—you can invest a lower amount of capital and depending on what happens, you might be able to make a higher percentage profit on it, or even a higher dollar-value profit on the spread. 

So basically, that’s kind of, in a nutshell, what you’re doing, is you’re maximizing your risk/reward and kind of putting it in your favor and creating the best strategy for that situation.

Give me an example of just a real simple call spread for our audience.

Sure. Say you have a stock that’s trading at $50 a share. You’re bullish, but you’re not super bullish, so you buy, in scenario A, I can go out and I can just buy the 50-strike call. Say I pay $2 for it. 

The stock goes up to $55. I hold it all the way to expiration. What do I make on that? Let’s see, if I paid $2 and the stock goes from $50 to $55, then it’s worth $5, so on my $2 investment, I made $3. 

Okay. Now, what if, instead, I created a spread? So, I buy that same 50-strike call for $2, but I sell the 55-strike call for $1.

So now, I’m only paying $1. If the stock goes up to $55, well, that spread is still worth $5. So I paid $1 for something that’s worth $5. 

That means on my $1 investment, I made $4, so I can have a much bigger profit and if it didn’t work out, I’d lose less, because instead of paying $2, I only paid $1. 

So, in some cases you may be minimizing or knowing the maximum amount of profit, but you’re also minimizing the loss. You know the exact amount you could lose on that, as well. 

Right. But you know, and I kind of need to warn though, it is a bit situational. 
If I think that the stock is going to go up to $80, well, the most I can make on that spread in that example is $4, but on the call, I can make a lot more, so you know, that’s why there are all these different strategies, because they’re all right for certain scenarios.

And with options, all that comes into play: the amount of time until expiration; not just am I bullish or bearish, but how bullish or bearish. Do I think the stock is going to up a percent, or 50%? That dictates what type of strategy and what type of spread I use in each scenario.

So, Dan, if I’m not sure exactly, I think it’s going to go up, but I’m not sure when it’s going to go up, what do I do there?

Yeah, well that’s another one of the things that you have to decide when you’re constructing a strategy, is not just okay maybe I’ll do a spread and I’ll do these strikes, but also which months, you know?

Instead of doing a May call spread, I might decide to do a June or July or August call spread.

So, time, the strike prices, both of these things come into play and it kind of helps you choose exactly which strategy, exactly which strategy—months and the strikes—that are appropriate for this specific situation.

And when you use options that way, you will really unlock a lot of power with them and you can really minimize your risk and really maximize your reward and kind of stack those odds in your favor.

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