Option spread trading strategy with any combinations of various expiry dates and strikes prices create spreads. It is entered by simultaneous purchase and sale of the same options class.
Option Spread constitutes a majority of the options trading strategy because of advantages it gives.
- Reduced Cost of Entering a Trade
- More Purchasing Power
- Limited Risk & Reward
How To Setup Spreads
Option Spread can be set up in various ways below mentioned are some of them.
- Buy a Call & Sell a Call
- Buy a Put & Sell a Put
- Buying a Stock & Selling a Call
- Selling a Stock & Buying a Put
The broad classification of Options Trading is classified into two Call Spread & Put Spread.
Based on the outlook and other variables such as Motivation, Max Loss/Gain, Profit/Loss, Breakeven, Volatility, Time Decay and Expiration Risk one should choose which is the right spread to execute.
The above call & put option spreads along with variations of expiry dates and strikes one can make combinations of various spreads. Hence forth any spread which is constructed using calls can be referred to as a call spread and similarly spread created using put are put spreads.
In a single spread call option and put option both cannot exist. Perhaps a combination of a call spread and put spread is possible.
Naked call or put carries higher risk so does it constitute higher margin. When it is hedged using a spread the total margin required reduces. This gives the trader more buying power with limited risk and limited profit. Below is the example which shows how spreads can give more buying power to the options trader.
This is an example of Naked Call Option and its margin requirement.
Source: Samco Securities
Combined Margin Requirement for Call Options.
Source: Samco Securities
The margin requirement for the naked call option is Rs. 57134.00 whereas when compared with a call spread it is Rs. 30567.00. There is a whopping difference of nearly Rs. 27000 which can give you the advantage to buying two spread at the same time reducing the risk and also limiting the profits.
Types of Spread
Option Spread is created by simultaneously buying and selling the same options type of the same underlying but difference in strike price and/or expiration dates.
The combination of different strike price and expiration dates one can conclude different types of spreads. The spread of different category is mentioned below.
- Vertical Spread
- Horizontal Spread
- Diagonal Spread
The above image is an easy explanation of different types of option spreads.
In Vertical Spread options of same underlying, same expiration dates but different strike prices.
In Horizontal Spread option of same underlying, different expiration dates and same strike prices.
In Diagonal Spread same underlying, different expiration and different strike prices.
Based on the outlook and motivation for the options trading a combination of Debit & Credit Spread or Bull & Bear Spread can be executed.
We Come to the End
Altogether there a lot of trading strategies available to the options trader.
The other combination based on debit & credit or bull & bear would be discussed in the upcoming posts.
We’ve earlier mentioned doing not trade naked options and keep all your positions hedged.Remember that options trading should be hedged all the time. Leave no naked Positions in options trading.
Spread contribute a majority of traders because of their nature of limited risk and limited profit.
I am sure you would have things to tell regarding your experience in Option Spreads.
Let us Know in Comments.