Investment goals generally include income or capital gains. Many investors believe income requires sacrificing some potential for gains. With popular investment alternatives, this is largely true. For example, bonds are usually thought of as income investors. If a bond is held until it matures, the potential gains are limited. Most changes in price are due to changes in interest rates and these are often ignored by long term investors who simply hold the bond for income.
On the other hand, stocks are usually bought and sold for capital gains. Dividends, some traders say, are a pleasant accident of trading. What they mean by this is that buy and sell decisions are often based on the price action and dividends are ignored. There are some stock market investors who focus on income. However, they usually stick to high income, low volatility stocks in order to minimize their risks. When volatility and income are both high, it is usually a signal that the dividend is about to be cut.
Of course, there are investment alternatives beyond stocks and bonds. These include options on stocks although options are often underutilized by individual investors. Most options trades are what professionals call “outrights” and involve buying or selling puts or calls. The term “outright: is defined as “open and direct” and most options trades are an open and direct bet on a directional move in price. A put option gains in value when a stock price declines. A call gains in value when a stock price rises. Simply buying and selling these instruments provides investors with a way to benefit from the underlying move in the stock.
Options can also be used in more complex strategies, including strategies known as spreads. A spread trade includes a combination of at least two different options contracts. While spreads may be slightly more complex to understand and implement, they can help a trader generate income, profit from directional market moves and limit risk.
A spread involves at least two options and each contract is known as a “leg” in the spread. There are at least two legs in the trade and there can be four, five or even more. Online brokers generally allow traders to open spreads as a single transaction. You enter all of the legs and all parts of the trade are executed at once. This avoids the problem of broken trades where you are only partly filled. Let’s look at how a simple spread would work.
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Let’s say you believe a stock is likely to rise in the future. You can benefit from this move by selling a put option. But, that creates a large amount of risk so you could also buy a second put with a lower exercise price to limit your risk on the trade. The put you sell would be more expensive than the one you buy resulting in a credit to your account. Assuming the stock moves as expected, the profit is equal to the initial credit. Assuming the trade moves against you, the loss is limited and known in advance. An example will clarify this point.
Consider a stock trading at $100 a share. You are bullish and expect the price to rise to $110. But you have limited funds available. To do so, you could sell a put option with an exercise price of $90 for $3. Each contract covers 100 shares so you generate $300 in income, ignoring commissions. Now, if the stock goes up, you keep the $300. In fact as long as the stock is above $90 when the option expires, you keep the $300. You face a loss if the stock falls below $90. If the stock falls to $50 for example, you would be forced to pay $90 a share for a stock valued at $50, losing $40 per share. Buying the put limits this risk.
If you bought a put with an exercise price of $80, you are protected against a decline below this amount. In this example, you bought that put for $0.50, paying $50. This means you generated $250 in income when opening the spread.
If the stock closes above $90 at expiration, you keep the $250. If the stock closes below $90, the put you sold loses money. The maximum loss is defined by the $80 put you bought. If the stock falls below $80, this put will have value. The maximum loss on this kind of spread is the difference between the exercise prices of the options offset by the premium you received.
In this case, the maximum loss is $750. That is the difference between the strike prices ($90 – $80 which is $10 multiplied by 100 to account for the contract size of 100 shares) offset by the premium received when the trade was opened. This information is summarized in the payoff diagram below which shows maximum risks and rewards are defined.
For the trade, the maximum gain is $250 and the maximum loss is $750. These values are always known in advance. Now, you might be asking why would a trader risk so much to gain a relatively small amount. The answer is in the probabilities. The trader may know there is a very high probability, maybe at least 85% or so, of a gain. Given this probability, it makes sense to open a large number of spreads knowing probability favors a gain in the long run.
That’s another advantage of trading options. The probability of success can be defined in advance. This means traders know the potential gain, the possible risk, the timeframe of the trade and the probability of success. With all of this information and with low margin requirements for the trades, many traders realize complex options can be useful, and profitable.
In the example above, a bullish trading strategy was implemented. It is also possible to develop a bearish strategy that involves selling and buying calls. This strategy is summarized with the payoff diagram shown below.
The example also included a credit when the trade was opened. Some trades will be known as debit spreads and involve a small outlay, or debit from your account, when the trade is opened. Again, the potential payoffs and risks are known in advance and probability may favor a debit transaction at times.
These basic strategies, a bull put spread and a bear call spread, are known as vertical spreads. A vertical spread uses options on the same underlying security and with the same expiration date, but at different strike prices. A horizontal spread would be a trade using options on the same stock with the same strike price but with different expiration dates. Horizontal spreads can benefit from time premiums in options or they can profit from trading ranges. They can also be completed as credit or debit transactions.
Spreads are a versatile options strategy that can be used by many traders. Probably the reason spreads aren’t used very often is because they are not widely understood. We will be addressing this problem in the coming weeks as we explain different spread strategies and provide examples of how they can be used.