Understanding Complex Options Strategies and Spreads
Options are an exciting choice for investors because they can offer less risk than traditional investments. Still, some degree of risk does exist, as with all investments, which is why strategies exist to minimize that risk.
Every options strategy works on something called an options spread.
In this article, we’re going to explain what a spread is in terms of options, and what some of the common options spread strategies are.
In finance, a spread refers to a range between two values. Depending on the context it is used in, it can have multiple meanings.
In its simplest form, an options spread is an options strategy that includes both buying and selling of options at different strike prices and/or different expiration dates on one underlying asset.
The important points of an options spread are:
- Must include both buy and sell (call and put)
- Must apply to the same underlying asset
- They differ on strike price, expiration date, or both
An options spread must have exactly the same number of long and short options and they must be of the same type, i.e., either call (buy) or put (sell). So, if you have two long call options then you must also have two short call options for it to be considered an options spread.
Call options are options to buy an underlying asset at a specified price. People who buy call options are bullish because they expect the stock to go up. People who sell call options are bearish because they expect the stock to go down. If the stock goes up, the buyer wins, and the seller loses. If the stock goes down, the seller wins the premium.
Put options are options to sell an underlying asset at a specified price. People who buy put options are expecting the stock to go down and people who sell put options are expecting it to go up.
Here are some examples using the stock XYZ, Trader A, and Trader B.
Let’s say XYZ is currently trading at $50.
Trader A expects it to go up to $60. Trader B expects it to go down or stay the same.
Trader B has stocks of XYZ. He sells Trader A a call option for $52 (the strike price) to be executed one month later. That means that Trader A has the right to buy XYZ for $52 one month later, regardless of the price that XYZ is trading at the time.
If one month later, XYZ is trading at $55, Trader A wins and Trader B loses $3 per stock. If it is trading at $50, Trader B pockets the premium for the trade and Trader A loses the premium.
In the above scenario, Trader A could also be said to be going long on the stock.
If we flip this around to a put option―the right to sell an option—it might look like this:
People who buy put options are usually bearish on the stock—they are shorting the stock. So, Trader B would buy the put option from Trader A, meaning that Trader B buys the right to sell stocks of XYZ to Trader A one month later, regardless of the price.
Because Trader B expects the stock to go down, he sells Trader A a put option for $50—this means Trader B has the right to sell that stock at $50 to Trader A at the option’s expiration date, regardless of what it’s value is. Trader A thinks the stock is going to go up, and so buys this option happily.
If the stock goes up to $60, then Trader B loses the premium they paid for the option. If it goes down to, say, $48, Trader B gains $2 per share because they can still sell the stock at $50.
Options spreads minimize risk by having the trader open up both a short and a long position on the same stock, effectively becoming both Trader A and Trader B. If a small range is used, the balance between the premium gained (or lost) and the resultant value of the stock can result in a net gain for the trader.
There are several variations of spread strategies, some simpler than others. The most common strategies are:
- Vertical Spread
- Horizontal Spread
- Diagonal Spread
Within these strategies, there are also sub-strategies, and to cover all of them in one article would be impossible. There are entire courses available to learn all the different types of spreads thoroughly. But, at a high level, investors can know that there are bullish and bearish (long and short) versions of the above strategies and that the elements of the strategy can be tweaked according to whether the investor feels the stock is going to go up or down.
In the vertical spread, traders go both long and short on the same stock, using the same expiration date but a different strike price.
The horizontal spread is also called a calendar spread. It uses long and short positions with the same strike price but with different expiration dates. In a horizontal spread, a trader can use the option with the further expiry date to potentially offset losses on the one with the nearer date.
The diagonal spread strategy is a combination of the horizontal and vertical spreads, lowering an investor’s risk by giving them the benefit of both the differing strike price and the different expiration dates.
Options spreads can get really complicated. The above are the simpler ones, believe it or not.
It is your advisor’s duty to explain how options spreads work completely and fully to you so that you understand the potential risks of any options spreads strategy that they might be using with your investment.
Also, only ever deal with advisors who are registered with FINRA.