One of the main advantages of options trading is that it can give you the chance to invest in an underlying asset at a reduced cost or with limited risk. The spread option strategy, including vertical, horizontal, and diagonal spreads, offers diverse setups. Today, we’ll see what an option spread is and take a look at more than one option spread example.
Key takeaways
- A spread option strategy is a trade setup that aims to provide exposure to options at a reduced cost or with limited risk. Spreads can be vertical, horizontal, and diagonal.
- Vertical spreads involve strategies with the same expiration date, such as bull and bear spreads.
- Horizontal spreads, also known as calendar spreads, utilize different expiration dates.
- Diagonal spreads are strategies that integrate both vertical and horizontal elements within their setup.
What Is the Spread Option Strategy?
What is an option spread? Well, you can see the spread option strategy his as a large group of different trade setups designed to lower costs and minimize risk. Here’s a table offering a closer look at some common types:
- Vertical Spreads: These involve buying and selling options with the same expiration date but different strike prices. Vertical spreads are popular in both bull and bear markets, helping traders capitalize on price movements with limited risk.
- Horizontal Spreads (Calendar Spreads): This strategy employs options with the same strike price but different expiration dates. It’s all about making the most of time decay and often involves selling a shorter-term option while buying a longer-term one.
- Diagonal Spreads: Combining features of both vertical and horizontal spreads, diagonal spreads allow traders to mix different strike prices and expiration dates. This offers flexibility and can be tailored to specific market views.
The main “selling point” of the spread option strategy is the ability to profit from a particular aspect of options (e.g., price movement, time decay, etc.) while reducing the risk and the cost. The rest of the article will focus on three real-life examples, which will help you better understand the mechanics of these strategies.
Option Spread Example #1 – Vertical Spreads
In general, you will find that vertical spreads in a spread option strategy can either generate a credit or a debit in your trading account. This is achieved through different spread options, such as bull put spreads and bear call spreads for credit positions, or bull call spreads and bear put spreads for debit positions. To better understand what an option spread is, let’s walk through a bull put spread example using Philip Morris (PM).
Suppose you believe in PM’s strong fundamentals, especially after it hit a new 52-week high. You decide to explore options spread trading by opening a bull put spread. Here’s how it might look:
- Buy a $120 put: This is an insurance-like move, where you buy the right to sell PM at $120, limiting your downside.
- Sell a $125 put: You sell the right for someone else to sell PM to you at $125, betting that PM will stay above this price.
Currently, PM is trading at $127.45. This setup involves both puts expiring in two weeks. According to our options screener, the P&L chart above shows a potential $410 loss against a $90 profit. It’s essential to weigh whether the trade-off is worth it.
Should You Take This Trade?
Before opening the trade, you should combine the P&L analysis with a look at the historical price chart:
Therefore, consider the points below:
- Risk vs. Reward: With a $410 potential loss for a $90 gain, consider if this aligns with your risk tolerance.
- Breakeven Analysis: The breakeven point is $124.10. You should assess the likelihood of PM staying above this level when the options expire.
- Trend Evaluation: PM has been on an upward trend for several months. Think about whether this bullish momentum can continue.
When evaluating such a spread option strategy, consider these factors:
- Is the historical trend supportive of another bullish period?
- Does current market sentiment back your strategy?
- Are you comfortable with the risk/reward ratio?
This is just one option spread example, illustrating how spread options can be tailored to specific market views and conditions. While this particular setup might not offer the highest profit ratio, it provides a structured way to engage in options spread trading with defined risks. Always ensure that your analysis is robust and aligned with your financial goals before proceeding.
Option Spread Example #2 – Calendar (Horizontal) Spreads
Horizontal spreads (or calendar spreads, if you prefer) can be easily understood through examples. Let’s consider Cloudfare (NET) as a case study to illustrate this spread option strategy. Suppose you think NET’s financial health is shaky, but you don’t foresee a drastic price drop in the next month. A calendar spread might be your go-to strategy.
Here’s how you could set it up:
- Sell a $75 put expiring in 10 days: This step involves selling a short-term put, collecting premium upfront, and betting that NET will not fall significantly.
- Buy a $75 put expiring in five weeks: By purchasing a longer-term put, you’re safeguarding against potential price drops over a more extended period.
With NET trading at $76.24, this setup allows you to profit if NET stays around $75. The P&L chart will show you need NET to trade between $71.40 and $79.43 at the earliest expiration for potential gains. Ideally, having NET around $75 at expiration can yield a peak profit of about $150. However, if NET’s price moves substantially, your losses are capped at roughly $150.
Should You Take This Trade?
Before opening this trade, combine the P&L analysis with the historical price chart below:
More specifically, these are the aspects you may want to consider:
- Limited Risk: Your maximum loss is confined to around $150, regardless of significant price movements.
- Potential Income: Successfully predicting NET’s price movement lets you potentially reap consistent profits. You can continually sell another short-term put as the previous one expires, which can turn this into a reliable income strategy.
- Historical Price Trends: NET has hovered between the breakeven points of your strategy recently. While not a guarantee, this is an encouraging sign that your prediction could be accurate.
- Market Sentiment: Assess whether market trends and news support your view on NET’s stability.
Option Spread Example #3 – Diagonal Spreads
Our last example concerns diagonal spreads (you trade options with different strikes and different dates, mixing up the two strategies mentioned earlier). This spread option strategy can offer flexibility and potential profits in options spread trading.
Let’s consider Walmart (WMT) for a practical look into this spread option strategy. Suppose you view WMT as a solid investment choice, and you’re interested in a diagonal spread.
Here’s how you might set it up:
- Sell a $78 call expiring in 4 weeks: By selling this option, you collect a premium, hoping that WMT will not exceed this strike price drastically.
- Buy a $77.5 call expiring in five weeks: This longer-term option provides a hedge, protecting you if WMT’s price surges.
Currently, WMT is trading at $77.34. The objective is for WMT to trade above $76.99 by the first expiration. Ideally, if it hovers around $78, you could see a peak profit of around $50. However, should the price fall below $76.99 or even down to $75, your maximum loss would be capped at about $50.
Should You Take This Trade?
Once again, combine the P&L analysis with the study of WMT historical price chart:
We each have our own way to analyze charts, but here is what you should keep in mind:
- Historical Price Trend: Reviewing WMT’s recent price history can be insightful. If WMT has been trading close to your breakeven price, this could suggest an accumulation phase, potentially preceding a price increase.
- Risk Management: A diagonal spread provides a controlled risk environment with capped losses, making it a manageable way to engage in options spread trading.
- Flexibility: Diagonal spreads offer the benefit of combining different strike prices and expirations, allowing you to adapt to market views and conditions.
- Potential Income: Regularly assessing WMT’s price movements and market sentiment can help in deciding whether to replicate or adjust this spread option strategy over time.
This option spread example highlights how understanding and applying diagonal spreads can enhance your trading approach. By carefully analyzing market conditions and historical trends, you can make informed decisions that align with your financial objectives. This spread option strategy enriches your trading and diversifies your investment strategies.
