What Are Option Spreads?
Option spreads allow you to take advantage of the high reward potential of option trading but with higher probabilities. So what is a spread? Simply put these are strategies you can create in the market by not just buying 1 option, but combining different options and strike prices. Each option that is in the trade is called a leg. So if you have a spread with 2 different options it has 2 legs. There are two main categories of option spreads, credit spreads and debit spreads.
These are one of the most popular ways to trade. When you enter a credit spread you receive a “credit” up front (or you make money up front). Then you keep your full profit if the stock stays in a certain area. An example would be a bull put spread. If you buy an $80 put for $3 and sell the $85 put for $4 your initial credit is $1, and you realize your max gain as long as the stock stays above $85. Credit spreads also have a max loss. It is the difference between the strike prices and the premium. In the example above the difference between the strike prices is $5 minus the $1 we made so the most we could lose on a trade like that is $4. You could also switch it around and make money using a bear call spread which would be profitable as long as the stock stays below a certain area. Bull put spreads and bear call spreads can also be combined to create an iron condor which is profitable as long as the stock stays between two levels. Covered call writing can also be considered credit spread strategy because you recieve money up front. The other major option spread strategy is the debit spread. When you enter a debit spread you receive a “debt” up front (or you lose money up front). But if the options are in the money they could be exercised and give you a higher profit. An example of this is the bull call spread. If we sell the $85 call for $8 and buy the $80 call for $12 we receive a debit of $4 up front, but if the stock stays above $85 by expiration it will be exercised and you will buy the stock at $80 and sell it at $85, making a profit of $5 minus the $4 we initially spent. You could also switch this around to create a bear put spread which would be profitable as long as the stock stays below a certain level. Different time frames There are also 3 different types of option spreads you can use when you consider timeframes. 1. Vertical spreads – Selling spreads that expire in the same month but with different strike prices. 2. Horizontal spreads – selling spreads that expire in different months, but with the same strike price. 3. Diagonal spreads – selling spreads that expire in different months and have different strike prices. Other Spreads In addition to credit and debit spreads there are other spreads that you can use to fit different needs. The butterfly spread is similar to the iron condor only uses both a debit spread and a credit spread. The covered call spread and collar spread fit into this category as well. They involve buying the stock and selling options on that stock. There are even spread options that can be used to profit from a big move in the market. The strangle and straddle allow you to profit from a stock as long as it makes a big move in either direction. Conclusion Option spreads definitely give you more of a variety to choose from when trading. But remember don’t try to trade everything at once. Stick to 1 or 2 strategies until you get them to work first. A couple good strategies is all you really need to be profitable. Other spreads
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