Options spread strategies come in many structures. However, there are some general core elements present in spread trading that new traders should know.
In this episode, we focus on understanding option spreads and how to trade them in your portfolio. While this is a significant subject that can be explored in depth, our focus here is an introductory approach to spread strategies.
What is an option spread?
An option spread is simply a multi-leg position with two contracts. Vertical spreads are a simple, beginner options trading strategy that you can use to express a directional bias with defined risk. Diagonal and calendar spreads are slightly more complicated, but we’ll explain the basics.
Vertical spreads get their name from how strike prices appear on an options chain. The spread width determines a vertical spread’s risk and reward profile.
Option spread examples
Credit spreads involve buying and selling call or put options. The short option’s strike price is sold closer to the underlying stock price, and the long option is purchased farther out-of-the-money.
Credit spread’s profit potential is limited to the initial premium you receive for selling the options. The risk is also limited. The max loss is the spread’s width minus the credit received.
For example, if you sell a $5 wide credit spread and collect $1.00, your max profit is $100 per contract, and your max loss is -$400 per contract.
Like credit spreads, debit spreads consist of buying and selling two options. However, the long option will cost more than the short option, so debit spreads require you to pay the difference in premium between the two options.
For example, if you buy a $50 call option for $6.00 and sell a $55 call option for $4.00, you’ll pay a total of $200 to enter the trade. The initial debit is your max risk, while the spread width minus the debit paid is your max reward, or $300 in this example ($5.00 - $2.00).
Calendar spreads, also known as horizontal spreads, consist of buying and selling contracts with the same strike price and different expiration dates. Calendar spreads look to capitalize on minimal price movement and time decay in the near-term option and rising volatility in the long-term call option.
Diagonal spreads get their name because they move diagonally across the option chain, not only the strike prices but also diagonally from one expiration period to the next.
Diagonal spreads benefit if the underlying stock price is above or below the short option at the front-month expiration. The later-dated option defines the strategy’s risk if the stock price moves significantly before the first option expires.
Key concepts for option spreads
The most important thing you should consider when choosing your strike price is how far that strike price is from the underlying security. The strike price’s proximity to the underlying asset will determine its cost. The closer the strike price is to the underlying security, the higher its delta and the likelihood it will finish in-the-money at expiration.
The further you go in time, the longer you have for the strategy to work out, and the more expensive the contract’s premium.
Choosing spread width
Most people, especially beginners, should trade the most narrow spread possible. The narrower the spread, the less risk associated with the position. Widening the spread width will increase risk and reward. We prefer to widen strikes versus going with more contracts if you have to choose.
Breakeven prices are the price at which you would need the security to exceed or stay above to break even on your trade. Breakeven points are determined by the strategy type and are above or below the long or short strike.
You add premium to call options or subtract premium from put options. Debit spreads add cost to your position, while credit spreads increase your profitability range and give the position a margin of error.
Fixed P/L and risk profiles
A great thing about spreads is they allow you to know what you can make or lose when you enter the position. Defined risk can be a huge help for beginning traders.
More complex management
Buying and selling spreads isn’t as straightforward as buying and selling stock. Because you enter two contracts, you also need to exit two contracts. It does mean a bit more complexity, but you shouldn't shy away because you have much more flexibility.