What makes spread options trading strategies so useful is the fact that they can be used regardless of the current conditions are bearish, bullish, or even neutral. Spread Strategy is also great when it comes to limiting risk without completely diminishing profits.
Vertical spread Strategy:
A vertical spread is a variation of the common spread option where the pair of options that you purchased, one long and one short, have different strike prices and the same date of expiration. For example, if you purchase a stock’s option for $60 while simultaneously selling it for $70 then you will have created a vertical spread.
To fully understand this strategy, assume that you own the underlying stock to a specific option, and the stock is currently worth $50, though you anticipate it rising to at least $55 relatively quickly. To take advantage of this fact, you would want to execute a vertical spread. This means you would purchase a call for $50 and simultaneously sell a put for $55. The $50 call is already going to be in the money so that it will have a premium of $1. The $55 put will have a 25-cent premium as it is currently out of the money. This means you would pay the $1 and make the 25 cents leaving you with a cost of 75 cents to orchestrate it.
With your setup in place, there are one 2 possible results. The stock will increase in price as you were anticipating or it will drop unexpectedly. If you end up making a poor prediction and watch the price drop to $45 from $50, then both calls will expire out of the money and you will just be out 75 cents. However, if the price rises as you have reason to believe it will, then the price is now $55 which means both your options have premiums, the first of $6 and the second of $1. The call you sold then becomes a naked call, and you will need to close out your position prior to the expiration date of the options to protect yourself.
You would then need to sell the $50 call for a profit while also buying back the $55 call that was previously sold. You would then be able to sell the call for $6 and, after that, purchase the other for $1. This means you would end up gaining $4.25 per share after transaction fees are taken into account.
If the price instead jumps to $60 rather than $55 your profits will still be limited in conjunction with the limited risk you faced with the transaction. If the price reaches $60, then this means the $50 call would be $10 in the money so it would have a premium of $11. The $55 call would also be in the money still with a premium of $6. This means your total profit would ultimately remain the same.
This is because after both calls have made it into the money, the total profit is always going to be hampered by the difference between the varying strike prices minus the cost of fees. This means the best-case scenario for this type of spread is for the underlying stock to reach the price of the put price but no higher as this will not help you to continue turning a profit. Despite the fact that profit potential is going to be limited, the fact that this type of spread costs less than a typical call option to execute makes it viable in scenarios where the price of the underlying stock is not expected to move overly much. This makes it the perfect choice for stocks that are stuck in a period of moderate bullishness.
Horizontal spread Strategy:
Horizontal spreads, also known as calendar or time spreads, are a type of spread that includes a pair of options with the same strike price but different expiration periods. Keep in mind that an option’s premium is always going to lose value based on the amount of time it has left before it expires as this means there is less of a chance that it is going to turn a profit. Furthermore, the closer it gets to the expiration date, the faster its price falls. The horizontal spread is useful in that it uses this decay in order to turn a profit.
For example, assume that you purchased an option in the middle of June for an underlying stock that you already own. To generate a horizontal spread, you are going to want to find the strike price of the option when it expires in August, which is $4, and the strike price of the option when it expires in September which would be $4.50.
To start the spread, you would then want to sell the August option because it is the nearer of the pair while also selling the option that has the farther expiration date (September). This means you would earn $4 on the first sale and then spend $4.50 on the second so it would only cost you 50 cents to set up overall.
You would then want to hold onto the pair of options for about a month until the first date is fast approaching. This close to the first expiration date, the premium will have dropped significantly, so it will now only cost $1.50, while the second premium will still be holding strong at around $3. When this occurs, you will want to close the spread position. To do so, you would want to purchase the first option back for $1.50 and sell the second option for $3, thus clearing a $1.50 profit or $1 after fees have been paid. This works for puts as well as calls.
Ratio spread strategy:
The ratio spread strategies outlined below are a variation of the vertical spread strategy discussed above. They involve using an option spread that takes advantage of the same expiration date for multiple trades. It is a strategy that is most effective with underlying stocks which have extremely low volatility overall which means it is most at home in a neutral market. As the name implies, both of these strategies involve creating a ratio of options sold when compared to those being purchased. This ratio will vary based on your needs, though the examples below work with a 2 to 1 ratio of sold options to purchased options.
Broadly, these strategies are going to be similar to the iron condor or the iron butterfly, though they have one important difference which is that they have a greater amount of risk if the underlying stock is unexpectedly volatile and a similar increase in potential reward. This risk is also offset thanks to the fact that they are generated using fewer options overall which means they are going to fewer associated costs as well.
The put ratio spread has a neutral risk and profit profile and is generated with 3 put options (in a 2:1 ratio). To create one, you will want to purchase a put option that is already in the money and sell the other two at a position that is currently just on the money. There is typically very little upfront cost for this type of strategy, and it may actually generate a small amount of profit each time it is used. This is because the cost of the option that is in the money will be very close, if not actually less than what will be made when you sell the pair of options that are already on the money.
When using this strategy, it is important to keep in mind that additional profit will not be made if the underlying stock price increases above the price of the option that is already in the money, just as it will not generate extra losses if this is not the case as all of the options would just expire if this were to occur. Once the price of the underlying stock decreases in the strike price, you will then be able to turn a profit by selling the option that is on the money that was already purchased. This profit will continue to increase as the price of the underlying stock continues to decrease.
It is also important to keep in mind, however, that after the price of the underlying stock decreases to a point where it is beneath the strike price of the options that were at the money then your potential for profit is going to decrease again. This is the point where the options that are at the money will cease to expire without issue and will need to be purchased back if you hope to prevent additional losses. Your losses are multiplied in this case as the number of options you have to buy back are going to be twice what you can compensate for by selling the option that you still retain.
This means that the put ratio spread has a neutral profit profile with a tinge of bullishness. As such, it can only hope to achieve maximum profit if the price of the underlying stock ultimately reaches the strike price of the option that was on the money. Once this happens, you will then want to sell the option that is already in the money and then let the other pair expire. Moving past this point, positive volatility will not create either additional losses or profit as all three of the puts will see equal levels of movement, canceling out the possibility of additional profits. On the other hand, unexpected negative volatility has the potential to generate extreme losses as nothing is holding them in check. The same general process can be used with calls as well.
Front spread strategy:
The front spread call strategy can be utilized by starting with a call that is either already in the money or just slightly beneath that point, as long as the price is still discounted. The end goal here is to take control of the call once it reaches the first strike price to ensure only a small loss or even a slight gain by then selling 2 calls at the second strike price. Both of these strike prices will need the same expiration month for the best results.
It is important to keep in mind that this strategy has a high ceiling when it comes to risk. As such, you will need to be sure to apply the correct technical indicators as a means for determining when it is the right time to make a move using this strategy.
For optimum efficiency, you will want to put this strategy into play if you are somewhat bullish when it comes to the underlying stock and you have reason to think it will reach the secondary strike price before hitting resistance. If you do not believe the market is strong enough for this to be the case, a different strategy is recommended. Ideally, the price of the underlying asset will move between the two strike prices relatively quickly.
This will then generate a cover for one of the calls purchased, while at the same time also leaving the second one open in case of additional gains. This potential for gain will also leave you open to risk if things take a sharp turn which is why it is important to keep an eye on the underlying stock when it is in play. It is also very important to always set a stop loss at a point just below the secondary strike price to ensure any potential losses are as minimal as possible.
The risk associated with this strategy can also be mitigated by the use of index options as opposed to regular options. Index options often make a reliable choice when you find yourself in need of a riskier options strategy as they will have less volatility than even regular low-volatility options. This is the case because there are so many different options operating at once that their movements tend to cancel one another out.
To get started with this strategy you will want to purchase a call at a profitable strike price and follow that up with another pair at a secondary strike price. The price of the underlying stock would then move enough to ensure that you will make a profit off the first and still have enough time to sell off the other pair of calls to fund a majority of the purchase price. Ideally, you will find an initial call that is very close to its expiration date to maximize your profit potential. This makes the ideal time frame for this strategy somewhere between 30 and 45 days. This strategy is also effective if you purchase the underlying stock directly rather than using uncovered calls which also mitigates some risk.
Remember, this strategy is effective because it puts time decay to good use as it reduces the value of the option you are buying while increasing the gain on each option you are selling. The same general process applies to puts.
Double diagonal put spread strategy:
To take advantage of the double diagonal strategy you will start with a diagonal put spread combined with a diagonal call spread. You can make a diagonal spread from a horizontal spread by moving the long leg to a strike point that has an altered time frame. It does not matter what the time frame change is, any spread with legs occupying different months is said to be diagonal.
With the diagonal call spread in place, you will then need to add in a short call spread as well as a long calendar spread to take advantage of time decay on the option. You will then eventually sell off the secondary call once it reaches the initial strike point that you backed into with the short call. This, in turn, allows you to generate net credits which means that anything above the price of the second call can be considered profit. The same basics steps apply to puts as well.
When you graph these lines, you are going to need to remember that the loss and profit lines will not be straight. This is because the 2-month options will still be active when the graphing occurs. Hard angles, along with straight lines will only exist if the options that are being graphed will all expire within the same time frame. While this may seem initially complex, it may help to think of it as a means of profiting from a market movement that is, more or less, neutral which is then spread out into several cycles of expiration.
Ideally, you will want to put this strategy to use when the underlying stock is about half of the way to the second call. The closer you can get it to the midpoint the more profitable the transaction will be. If you do not time it properly then it is more likely that market biases will intrude and skew the results towards bearishness or bullishness. When the stock stays near the midpoint, then the options you sold will expire at no loss which means you will be allowed to keep a larger overall amount of the premium.
This takes place because the second call and the first put you bought both serve to mitigate the overall risk regardless of how much the asset ends up moving. Ideally, it will work out in such a way as to generate a net credit, though this may not always occur. This is because the front-month trades will naturally have less time left, and thus, may result in net debts from time to time. When this occurs, you will often be able to make up the distance by selling off any remaining options after the pair for the front-month expired.
When this possibility becomes a reality, assuming the underlying stock price is at least at the price of the first call and not yet at the price of the second put then you will want to purchase another option that is near the pair of puts to create an additional put at the secondary strike price at the price of the third call as well as the third strike. These newly-minted options should also share the strike price with the other options from the secondary month. This process is known as rolling out and can sometimes serve to generate significantly increased profits.
Skip strike butterfly call spread Strategy:
What sets the skip strike butterfly call spread, and your average butterfly spread is that the first is significantly more focused on the direction the price is moving in than the latter. With this version, you will want to ensure that the price of the underlying asset is going to increase, just not so much that it clears the limits of your secondary strike price. The calls at the second strike as well as the fourth point will then be close to 0, and you will retain the premium that was created by the call placed at the original price point.
This strategy combines a butterfly long call spread with a classic short call spread. This means you unload the short call spread to generate the profit that will pay for the butterfly. As each of these strategies involves buying a call at the same price you sell it for, you can skip this step. The spread that is created on the short call then means that this strategy does not require much regarding the extra cost to generate the potential of significantly improved profits.
As such, it also adds additional risk to the equation. To get the ultimate results from this strategy, you are going to need that each of the proposed strike prices is going to be equally spaced with retaining the same expiration month. Ideally, the price with then remains below or at the primary strike price while not rising any higher.
To use the skip strike butterfly call spread with the best results, you will want to start by purchasing a call at the initial strike price. Next, you are going to need to sell two different calls at the secondary strike price. Last but not least, you will need to skip the third strike price and buy into a call at the final strike price.
This is an especially useful strategy if your primary goal when trading options is to ensure that your risk is as low as it could be. This is because the underlying stock would need to see substantial movement prior to breaking through to the strike price’s resistance. Risk can mitigate to an even greater degree if you add indices into the mix as they have even lower overall volatility still. This strategy is also useful if you are feeling bullish about the current state of the market and feel as though that outlook with continue.
Even better, as long as you are lucky to continue to see a movement to the third strike price then you can realistically expect to make a profit, even if the expiration point is one that would generally just allow you to barely break even. To ensure you generate as much profit as possible, you will need to commit at the moment and decide if it is worth exercising the moment the stock reaches the secondary strike price. If this is the case, you will then see profit based on the price of the first strike price subtract from the second strike price.
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