The Options Spread

The basic options spread involves the purchase of one option and the sale of a corresponding option.  Spreads can be done with either calls or puts.  Spreads can work very well by limiting the risk involved, however, they also limit the upside.  Spreads can be a very cost effective way to profit from the stock market, while at the same time limiting the risk.

Spreads have many names, but do not let that scare you.  As I said before, half of understanding anything is learning the “language”.  I will attempt to explain them in plain English.

The first Spread that I will explain is the Vertical Spread.

The Vertical Spread consist of buying a Call (or Put) and selling a Call (or Put) with the SAME expiration month, but with DIFFERENT strike prices.  That’s it.  Not very difficult.  This position will have a LIMITED loss potential, as well as, a LIMITED gain potential.  In other words, when you enter the trade you will KNOW the maximum gain and the maximum loss that can occur. 

Sometimes, you will hear of a Credit Spread or a Debit Spread.  A Credit Spread means that you will receive a positive inflow into your account (a credit) when you open the trade.  A Debit Spread means that you will pay (a debit) when you open the trade.

There are essentially four different Vertical Spreads that one can enter, they are:

          1)  The Bull Call Spread

          2)  The Bear Call Spread

          3)  The Bear Put Spread

          4)  The Bull Put Spread

next up – a discussion of the Bull Call Spread

Trading Idea

Diagonal Spread Example:

Sell GGBBU            Feb 2009    7.5 Call            $0.35

Buy KDMAZ            Jan 2010   2.5 Call             $4.40

 

Net Cost                      $4.05(+Trading Costs)

 

Maximum Loss            $4.05(+Trading Costs)

 

GGB is trading for        $6.54 at the close on Tuesday 01/27/09

 

If GGB trades above $7.50 on February 21, 2009 the gain will be $0.95(Less Trading Costs).  Lets assume $0.50/share trading costs, the return would be approximately 11% for 25 days.  Not Bad, but this is not what I am looking for.

 

If GGB does not go above $7.50, AND

 

If GGB trades at $6.54 on January 16, 2010 the loss would be $0.01(+Trading Costs), however this assumes that you do not sell more call options during the year.

 

If GGB trades much lower, this is the worst case scenario, however GGB is trading near its lows for the past year.  The Maximum Loss is $4.05(+Trading Costs) no matter what happens to GGB.

 

If GBB trades much higher, the return will depend if there are any outstanding options that have been sold.  At some point, if GGB trades much higher and you still own the $2.5 options, we can protect some gains by buying puts.  Let’s see where it moves.