An options spread can take on many forms. It may be helpful to think of a spread like a bridge that connects two (or more) options and, when combined, the spread can offset some of the risk of holding a single option. Limiting risk with spreads can also limit future gains.
Individual investors (with proper approval, if trading options) can sometimes apply options spread trading strategies within their portfolios, but it's critical to first understand how spread trading works as well as know your investing or trading mentality and risk tolerance.
The following are a few key questions and basics on spread trading.
What is a spread trade?
In the options world, the term "spread" includes a wide array of different strategies that involve buying an options contract and selling another. The components of a spread trade are options of the same type (puts or calls) on the same underlying security, and the trade will be either a debit or credit in a trader's account, depending on the net premiums of the strike prices that are bought and sold. A debit scenario means that the total premiums of options bought cost more than the total premiums of options sold. A credit scenario means that the total premiums of the options sold are greater than the total premiums of the options bought.
A vertical spread is a two-leg strategy that consists of two different options (either all calls or all puts) within the same expiration date but with different strike prices. Meanwhile, a horizontal spread, also known as a calendar spread, involves buying options in one expiration and selling options (of the same type, all calls or all puts) in a different expiration but with the same strikes.
Other more complex spread types include ratio spreads (different number of contracts that are bought versus sold), diagonals, butterflies, and condors. Spread trading requires proper approval before trading. Here we cover two strategies (vertical and calendar spreads.)
What are the benefits of spread trading?
In many cases, options spreads allow traders to theoretically define their risk. That is, they know how much they stand to profit or lose before entering the spread trade. While risk may be typically defined in advance, profit potential may be usually limited as well.
Some investors strive to track broad market indexes like the S&P 500® over the long haul, but spread traders are more likely to be thinking aggressively and trying to outperform the broader market. Or they may aim to capitalize on a short-term hunch without affecting their longer-term strategy or goals.
What are the risks of spread trading?
While spreads allow traders to express short-term views and fine-tune trades, they must also be comfortable with the additional risks involved. Because an options spread requires two options, the trade fees to establish and/or close out a spread will be higher than those for a single leg strategy. Option spread traders should always be aware of the potential for early assignment. There's a chance traders could be assigned early (before expiration) on a short call or short put. A short call is more likely to be assigned early if the underlying stock is going ex-dividend, the call is in the money (ITM)1, and the dividend is greater than the time value2 left in the call option. If the trader is assigned the call early, resulting in a short stock position prior to the ex-dividend date, the trader could be liable to pay the dividend. A short put option is more likely to be assigned early if the put is ITM and has lost most or all of its time value.
- A long call exercise results in buying the underlying stock at the strike price.
- A short call assignment results in selling the underlying stock at the strike price.
- A long put exercise results in selling the underlying stock at the strike price.
- A short put assignment results in buying the underlying stock at the strike price.
Traders often exit their positions prior to expiration to eliminate exercise and assignment risk that occurs with expiring ITM options. Holding an ITM options position to expiration can result in an exercise and/or assignment, possibly resulting in a long or short stock position and a risk profile that may be very different from the original options strategy. Spreads require active monitoring to determine if holding until expiration is warranted as the stock moves higher or lower. The amount of money at risk with each trade depends on the spread type (see more below).
The calendar spread is one example of a spread trade. It can be created using any two options of the same underlying security or index, strike, and type (either both options are calls or both options are puts) but with different expiration dates. In the spread, the trader typically pays a debit to buy an option at one expiration and sell one with a shorter expiration at the same strike. The debit calendar spread is designed to be a defined-risk spread.
Debit calendar spreads are typically intended to profit from the passing of time, not necessarily the movement in the underlying stock. Over time, the goal is for the shorter-term option to "decay," or lose value faster than the longer-term option, so the position profits when the spread can be sold for more than you paid for it (risk is typically limited to the debit incurred).
For example, if a stock is trading at $50 in late September, and the trader thinks it will hold a tight range around that price for at least a few weeks, they might buy one November 50 call for $2 and sell one October 50 call for $1.25. The trader would then own a long October/November calendar spread for a $0.75 debit (not including transaction fees). This debit would be the theoretical max loss.
How does the trader profit? If the shorter-term option "decays," or loses value faster than the longer-term option, the spread may be worth more, and the trader may be able to close out the spread for a profit.
All things being equal, if the stock finished at $50 at expiration of the short option, the short option would likely be worth zero. If the long option is trading at $1.25, it could potentially be sold to close and the trader would experience a $0.50 profit (less transaction costs). If the short call expires worthless and the trader holds the long call to the expiration, and it too expires worthless, then the result is a 100% loss on the spread (the debit), plus transaction fees.
A vertical spread is an options strategy composed of either all calls or all puts, with long options and short options at two different strikes. The options all have the same underlying instrument, the same expiration, and the same number of contracts on each leg of the spread.
If the trader is feeling bullish, they might consider a long call vertical (buying a call at one strike and selling a call with a higher strike) or a short put vertical (selling a put at one strike and buying a put with a lower strike). Alternatively, long put verticals (buying a put and selling a put with a lower strike) and short call verticals (selling a call and buying a call with a higher strike) are considered bearish strategies. In addition to transaction fees, the risk of a long vertical is typically limited to the net debit of the trade, while the risk of the short vertical is typically limited to the difference between the short and long strikes minus the net credit received. Also, keep in mind that carrying options positions into expiration can entail additional risks. For example, an unanticipated exercise/assignment event could occur, or an anticipated event may fail to occur.
Spread trading can be a valuable component of an investing strategy for some investors, but it can also get very complicated, very quickly, and go into the realm of speculation. In fact, many traders use spread trading exclusively for speculation. It’s important for those considering spread trades (or any investing strategy) to also consider how well options fit within their portfolios. Some will want to use a combination of approaches, but they must first understand the potential risks.
1An in-the-money option has value that can be realized through exercising the contract. A call is ITM if the stock price is above the strike price. A put is ITM if the stock price is below the strike price.
2Time value is the portion of an option's premium that is attributable to the time remaining until the option expires. All else being equal, the option with the more time remaining until expiration will be worth more due to time value.
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. Margin trading increases your level of market risk. For more information, please refer to your account agreement and the Margin Risk Disclosure Statement.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any options transaction. Call Schwab at 800-435-4000 for a current copy. Supporting documentation for any claims or statistical information is available upon request.
Commissions, taxes, and transaction costs are not included in this discussion but can affect the final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account.
Multiple-leg options strategies will involve multiple commissions.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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