A spread is an options strategy that requires two transactions, usually executed at the same time. You purchase one option and write another option on the same stock or index. Both options are identical except for one element, such as strike price or expiration date.
How you hedge with Spreads
If stock LMN is trading at $45: Investor A sells a call with a strike price of $40, and purchases a call with a strike price of $55. He receives $720 for the call he sells, since it is in-the-money, and pays only $130 for the call he purchases, since it is out-of-the-money. His cash received, or net credit, so far is $590. Investor B writes a 40 call on LMN, and receives $720. His net investment is the margin his broker requires for a naked call.
Why trade Options with Spreads
Many options investors use spreads because they offer a double hedge, which means that both profit and loss are limited. Investors who are interested in more aggressive options strategies that might expose them to significant potential losses can hedge those risks by making them one leg of a spread. The trade-off is that the potential profit is limited as well. It might help to think of spreads as a form of self-defense. Just as you can open an options position to protect against losses in a stock position, you can open an options position to protect against losses in another options position.
Executing a strategy
The first step in executing a spread is choosing an underlying security on which to purchase and write the options.
Next, you’ll have to choose the strike prices and expiration dates that you think will be profitable. That means calculating how far you think a stock will move in a particular direction, as well as how long it will take to do so.
You should be sure to calculate the maximum profit and maximum loss for your strategy, as well as the circumstances under which you might experience them. Having realistic expectations is essential to smart options investing.
Finally, you’ll have to make the transactions through a margin account with your broker. The minimum margin requirement for a spread is usually the difference between the two strike prices times the number of shares covered.
Investor A at Expiration
If the stock price rises to $60 at expiration: Investor A’s short call is in-the-money, and he must sell 100 LMN shares at $40 each. However, his long call is in-the-money as well, which means he can buy those same shares for $55 each. His net loss for each share is $15, or $1,500 total. This is offset by the premium he received, reducing his maximum potential loss to $910.
If the stock price falls below $40 at expiration: Both of Investor A’s options expire out-of-the-money, and he keeps the $590 for the maximum profit.
Investor B at Expiration
If the stock price rises to $60 at expiration: Investor B’s short call is in-the-money, and he must sell 100 LMN shares at $40 each, for a total loss of $2,000 over their market price. His credit offsets this by $720, reducing his maximum potential loss to $1,280.
If the stock price falls below $40 at expiration: Investor B’s option expires out-of-the-money, and he keeps his entire $720.
Types of Spreads
Vertical Spread: It is the most common in which one option has a higher strike price than the other.
- Calendar Spread: A calendar spread is the purchase of one option and writing of another with a different expiration date, rather than with a different strike price. This is usually a neutral strategy.
Straddle: A straddle is the purchase or writing of both a call and a put on an underlying instrument with the same strike price and the same expiration date. A buyer expects the underlying stock to move significantly, but isn’t sure about the direction. A seller, on the other hand, hopes that the underlying price remains stable at the strike price.
Strangle: A strangle is the purchase or writing of a call and a put with the same expiration date and different—but both out-of-the-money—strike prices. A strangle holder hopes for a large move in either direction, and a strangle writer hopes for no significant move in either direction.
Source: The Options Industry Council
otherwise known as OIC.