The Advantages of Option Spread Trading
Some Big Advantages
If you decide to create consistent positive cashflow from option trading, you may wish to consider the advantages of options spread trading over simply buying calls or puts and hoping for the market to go in the anticipated direction. Option spreads can be used in a number of ways, from the simple debit or credit spread, to more advanced and complex strategies such as the calendar spread, the butterfly, the iron condor and the like.
So what is it that defines an option spread? It is simply about taking opposite positions in terms of buying to open and selling to open (ie. writing) a number of option contracts for the same underlying financial instrument, but using different strike prices or expiry dates, thus creating a spread of positions as part of a single strategy.
Creating a spread can give a number of advantages. Firstly, although it will cost you more in brokerage, the overall position will usually be cheaper than just straight out buying. This can make all the difference if your trading capital is not very much. Your trades will cost less, so you have more control over money management.
Secondly, a spread will usually eliminate or reduce the element of option price volatility, or at least allow you to use it to your advantage. Volatility is when an option strike price becomes inflated or deflated in comparison to the historical volatility of the underlying, due to high or low demand at the time.
Thirdly, a spread will allow more flexibility when choosing the expiry date. Because you are selling to open as well as buying, you can often stretch out the expiry date of both positions without affecting your overall cost for the trade. This will allow you more time to be right and make a profit.
With spreads, you can sometimes take advantage of the situation even when the price goes against you. Let’s say you have taken a call debit spread, seeing that the price of the underlying has fallen recently and believing it is due for a rise. But to your disappointment, it continues to fall. This now means that your ‘sold’ position, being further ‘out of the money’ than your bought positions, will be very cheap. So you can now buy it back for a fraction of what you received for it. If you’ve allowed yourself plenty of time, you now hold only your bought position and simply wait for the underlying price to rise again.
You could even now ‘average down’ by taking out another call debit spread at lower strike prices. The combination of this new spread, plus the long call still held from the old position, could make you well over 100 percent profit on your investment, even if the stock only returns to its original level at the time of your original trade.
The above scenario assumes the underlying is not now taking a long term nosedive due to some financial crisis or extremely bad news. If this happens, you would start concentrating on bear put spreads. The profit on the put spread would offset the loss on the call spread.
Types of Options Spreads
Debit Spreads – are when you simultaneously buy a position with a strike price close to the present market price of the underlying stock or whatever – and sell to open for the same expiry date but further away from the current market price. This will take funds from your account and is therefore called a debit spread.
Credit Spreads – these occur when you do the opposite to the above. You sell closer to the current market price of the underlying and buy further ‘out of the money’. Since the option prices closer to the money will be more valuable than those further away, you will receive a credit to your account.
Other Spreads – There are more advanced strategies, such as ratio backspreads, range trading spreads like calendar spreads, butterflies and condors – and delta neutral spreads such as straddles and strangles. They are more difficult to explain and each one of them could be the basis for an article in itself.
Options spread trading provides the trader with some powerful advantages over simply ‘going long’ on an option contract. These advantages give greater flexibility when things go wrong, decrease your cost per trade and allow you to extend the expiry date of your positions (assuming there is sufficient open interest) at little or no greater expense. There are some other things you need to pay attention to, but if you understand what you’re doing, there is a tremendous amount of money that can be made.
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