by Amanda Harvey
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Creating option spreads is a technique frequently used in option trading. These spreads are constructed by concurrently buying and selling an equal number of options with the same underlying asset. These options are also of the same type; in other words, either both call options, or both put options. The difference between the two option contracts used in the creation of a spread can be in the strike price, the expiration date, or both.
Option spreads are broadly grouped into three types, depending on which factors differ between the two options used in their formation.
Three Basic Forms of Spreads
Spreads which are formed with the use of option contracts that have the same expiration date but varying strike prices are known as either vertical spreads, or money spreads.
The second type of spread is called the calendar spread or the horizontal spread, and the options used in this spread have the same strike price, but differing expiration dates.
A third form of option spread is the diagonal spread, which uses both a different expiration date and a different strike price, and takes its name from being a combination of the horizontal and vertical spreads.
Using Option Spreads
The basic principle behind using spreads is that the premium received for executing the sale component of the spread helps to reduce the cost of buying into the other part, or leg, of the spread. It is possible that the premium obtained from the option sale actually exceeds the amount paid for the option purchase, and in this instance it is deemed a credit spread, and some profit is already obtained at the outset. If the cost of the purchase is more than the amount received for the sale, it is classed as a debit spread, and its initial benefit is in the reduction of the outlay required for buying into the option.
Another important fact to be aware of when using spreads is that they help to limit risk, but they also limit potential gain.
Using a vertical spread, which is a spread in which the strike prices vary between the option bought and the option sold, is basically a directional strategy. In other words, it is important to have a definite opinion on the direction in which the market is likely to move.
A bull call spread is one type of vertical spread that can be used in the event that the trader expects a price to rise moderately. One call option is sold with a higher strike price than the strike price of the option which is simultaneously bought.
For example, a bull call spread is established for a stock which is trading at $10. The trader sells a call option with a strike price of $15, while buying a call option with a strike price of $12. If, at expiration, the stock is trading at $18, the trader can buy the shares at $12 and then sell them at $15. In effect, the maximum profit on this spread is the difference between the two strike prices. In the event that the price fails to rise, the loss sustained is the cost paid to buy into the spread (if it is a debit spread).
Setting up the Spread
While it is possible for a trader to ‘leg into’ a spread trade, which means establishing one part of the trade at a time, it is risky to do so, as the price may move unfavorably before the spread is fully set up. It is advisable to use a spread order with a limit order which will ensure that either the full spread is created according to plan or the entire order goes unfilled. This is important since most spreads have a limited earning potential and if appropriate strike prices are not obtained, the spread will not be worthwhile to enter into.
Option spreads can be an effective way of reducing the initial costs involved in trading stock options. Understanding the different types of spreads and when and how to implement them is a worthwhile area of knowledge for anyone participating in the arena of option trading.