SPREAD THE MONEY

A spread is the simultaneous buy and sell of two options on the same underlying with different strike prices and/or expiration dates. Utilizing spreads are a great strategy to help limit your risk on a short trade or help cover a portion of the cost on a long trade. If an investor feels the underlying will move higher, a long put spread or a long call spread would be a good trade to put in place. Conversely, if an investor feels the underlying is going to move lower, a short put spread or a short call spread would be a good trade to execute.  In both the long put and long call spread you sell the higher strike. In both the short put and short call spread you buy the higher strike.  An investor may want to use on the money, in the money or out of the money strike depending on the market environment. An investor may also choose to utilize a calendar spread which can be beneficial in a number of ways. A calendar spread may help reduce the cost of the long position while allowing for additional potential gains. If an investor anticipates an upcoming event may move the underlying, but is unsure of the release date, a calendar spread allows them to re-enter into a position and not have to purchase additional legs. Below are a few hypothetical examples of spread trades and the market conditions in which  they would be profitable. For these illustrations XYZ is trading at 100.

Long call spread 

If an investor feels XYZ is going to move higher they would go long the 100 call for $5 and write the 110 call for $1 reducing the cost of the long position.  If XYZ closes higher than 104 on expiration they realize a gain, with $6 being the maximum profit, the difference between 100 and 110 minus the $4 cost of the premium.  If XYZ closes below 100, the maximum loss is $4, the difference between the cost of the 100 premium and the sell of the 110 premium.

Short call spread

If an investor feels XYZ is going to move lower or remain stable they would write the 100 call for $5 and go long the 110 call for $1, which creates protection if XYZ moves higher than 110. If  XYZ closes below 100 on expiration, the maximum profit is $4, the sell of the 100 minus the purchase of the 110. If XYZ closes above 110 on expiration the maximum loss is $6, the difference between 100 and 110 minus the $4 premium received.

Long put spread

If an investor feels XYZ is going to move higher or remain stable they would write a 100 put for $5 and go long a 90 put for $1.   If XYZ closes above 100 on expiration the maximum gain = $4, the difference between the sell of the 100 and the buy of the 90. If  XYZ closes below 90 on expiration the maximum loss is $6, the difference between 100 and 90 minus the $4 premium received.

Short put spread 

If an investor feels XYZ  is going to move lower they would  go long a 100 put for $5 and write a 90 put for $1, reducing the cost of the long position. If XYZ closed below 96 on expiration they would realize a gain with the maximum gain = $6, the difference between 100 and 90 minus the $4 cost of the premium.  If XYZ closes above 100 on expiration the maximum loss is $4, the difference between the cost of the 100 minus the sell of the 90.

Calendar spread

Although the earnings release date for XYZ falls after May expiration, Tom anticipates a pre-announcement prior to expiration which he feels will move XYZ higher. In the event the pre-announcement doesn’t occur, Tom wants to have an XYZ position on the date earnings are released. The ask on the May XYZ 100 call is $5, the bid on the May 110 call is $1, due to expected volatility from earnings; however, the bid on the June 115 call is $3. Tom buys the May 100 call for $5 and sells the June 115 call for $3. With the additional June premium Tom’s maximum gain increases to $13 from $6 and reduced the cost of his May call to $2 from $4. Tom now has the potential to realize a gain in May or create a June spread by going long a June call establishing the potential to realize a gain in June.

The Math

May 100 long call $5 - June 115 short call $3 = total cost of $2.  If XYZ closes below 100 on June expiration the maximum loss is $5 premium paid - $3 premium received = $2. If Tom goes long a June 100 call and XYZ closes above 115 on June expiration, the maximum return is a $15 gain on XYZ - $2 premium paid on May call  - premium paid to purchase June call.

All investments carry risk, but spreads allow an investor to take advantage of moves in the underlying while utilizing leverage or decrease the cost of a long position while creating the possibility of a realized gain without owning the underlying.

Refer to Glossary for terms and definitions

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RISK is inherent in any investment. No individual or entity should invest with funds they cannot afford to lose. Option trading is time sensitive and involves risk including, but not limited to, loss of gains and principal. A leveraged investor risks the loss of  more than principal. Options do not have to be held until expiration and can be exercised at any point.  Option trades can be closed prior to expiration with a gain or loss being realized. It is important that you understand all trades and the risk associated before executing a transaction. The Option Profit provides broad ideas, not individual recommendations, and is not responsible for any losses incurred. Diversification is important with any strategy and should be considered when investing  Before trading consult with a financial advisor to determine if option trading is appropriate for you and your financial goals.