Tap Into a World of Profits
If you’ve ever traded options, you know they’re a great way to gain leverage and limit your risk. But if you’re only making straight call and put trades, there’s a whole world of profits you’re not tapping into.
One of our favorite strategies is spread trading. Why’s that? Simple. Some of our biggest profits have been made from spread trades, including:
All right, you get the picture. So now we want to spread the wealth by introducing you to the world of spread trading that has made us so much money.
Credit spreads involve simultaneously writing (or selling) a call or put option and buying the same type of option with a lower strike price on the same stock with the same expiration date.
When you initiate a credit spread, you are essentially buying one option to “cover” the risk you take when you write the other option. With credit spreads, investors receive a net credit for entering the position, and subsequently they want the spreads to narrow or expire for profit.
Because you can initiate a credit spread with either calls or puts, the strategy can be used whether you think the market (or particular security) is going to rise or fall.
The flipside of the credit spread is the debit spread. This strategy involves the buying of an option for a higher premium and selling another option on the same underlying asset at a lower premium.
You profit from a debit spread when there is a big change in the price of the underlying asset that increases the value of the option with the higher premium. The option with the lower premium then essentially serves to hedge risk. With debit spreads, investors incur a net debit for entering the position, and subsequently they want the spreads to move further.
Because you can initiate a debit spread with either calls or puts, the strategy also can be used whether you think the market (or particular security) is going to rise or fall.
Learn more about debit spreads.
A vertical spread is a trade in which the investor simultaneously buys and sells the same class option (either puts or calls, but not both) on the same underlying stock. Vertical spread trades also must be done using the same expiration month, but they involve different strike prices.
Verticals can be either credit spreads or debit spreads depending on the circumstances of the trade. What’s interesting about verticals is they can be used in a variety of ways to help you profit when you are either bullish or bearish. The following table shows the variety of vertical spreads available to investors:
As you can see, there are bull call spreads, bull put spreads, bear call spreads and bear put spreads. The versatility and flexibility of verticals allow them to be employed in a slew of situations to help option traders collect profits.
Butterfly spreads are basically a combination of a debit and a credit spread. The key to defining the trade as a butterfly spread is that it must be constructed with the same option class; either calls or puts. There are two basic types of butterfly spreads: call butterflies and put butterflies.
A call butterfly spread is made up of a debit call spread and a credit call spread. Many times the reference to a debit call spread is made by using the term “long vertical call spread,” whereas a credit call spread is also known as a “short vertical call spread.” Some traders call a short vertical call spread a “bear call,” while a long vertical call spread is called a “bull call.”
The put butterfly is made up of a debit put spread (bear put) and a credit put spread (bull put).
This strategy works best in a sideways trending market, as the real benefit from this kind of trade comes from time decay.
A condor spread is similar to a butterfly spread, and like the butterfly, a condor is an option strategy that uses either calls or puts. The only real difference between condors and butterflies is that there is a separation between the strike prices of the bull and bear spreads in the condor, while there is no separation (the spreads share one strike price) in the butterfly. Also like a butterfly spread, the condor strategy works best when stocks are trading within a tight range.
A regular condor spread should not be confused with an iron condor spread. The latter consists of both call and put options in the same trade, and is considered a credit spread, while condor spreads are debit spreads.
Learn more about the difference between iron condors and condor spreads.
A calendar spread, sometimes called a “horizontal spread” or a “time spread,” is made up of options in the same underlying equity, the same type of option and even the same strike price; however, they have different expiration months. Like so many plays in the options world, calendar spreads profit from the difference in time decay between longer-term options and shorter-term options.
There are two primary types of calendar spreads: call spreads and put spreads. A calendar call spread, as the name implies, uses calls to profit primarily from the difference in rate of premium decay between the near-term short options and the long-term options. (A near-term option premiums decay faster than long-term option premiums.) Because the calendar call spread buys LEAPS, which are more expensive than the short-term options sold, it results in a net debit.
A calendar put spread uses put options instead of call options, and also is a net debit trade, or debit spread.
Learn why Calendar Spreads Pay Larger Premiums.
A diagonal spread is a combination of a horizontal spread and a vertical spread. It involves the purchase and sale of two options of the same type (both calls or both puts) on the same stock that have different strike prices and different expiration dates.
It is similar to the calendar spread in that the trader is attempting to profit from the difference in rate of premium decay between the near-term short options and the long-term options. The difference is that the trader of the diagonal spread has a slightly more bullish or bearish short-term outlook.
If a trader has a bullish short-term outlook on a stock, they would use a diagonal call spread, i.e., selling a higher strike near-month calls against lower strike calls with a further out expiration date. A trader with a bearish short-term outlook would create a diagonal put spread by substituting puts for calls.
Learn more about diagonal spreads.
You’re on Your Way
All of these spread trades, as well as the many versions of these trades such as three-legged spreads, zero debit spreads, etc., are strategies options traders can use to help mitigate risk and add to their bottom lines in a given trade.
To be certain, these techniques take both time and effort to learn how to use effectively, and you probably shouldn’t start out trading options by employing any complex spread trades. But if you have a basic understanding of the principles involved in each trade, then you can definitely use these strategies to help spread the wealth.