You can limit your exposure using two or more options on the same stock.

A spread is an options strategy that requires two transactions, usually executed at the same time. You purchase one option and write another option on the same stock or index. Both options are identical except for one element, such as strike price or expiration date.

The most common are vertical spreads, in which one option has a higher strike price than the other. The difference between the higher strike price and the lower strike price is also known as the spread. Different spread strategies are appropriate for different market forecasts. You use a bear spread if you anticipate a decline in the stock price. You use a bull spread if you anticipate an increase in the stock price.

How do you hedge with spreads?

If stock XYZ is trading at $45: Investor A sells a call with a strike price of $40, and purchases a call with a strike price of $55. She receives $720 for the call she sells, since it is in-the-money, and pays only $130 for the call she purchases, since it is out-of-the-money. Her cash received, or net credit, so far is $590. Investor B writes a 40 call on XYZ, and receives $720. His net investment is the margin his brokerage firm requires for a naked call.

If the stock price rises to $60 at expiration:

Investor A’s short call is in-the-money, and she must sell 100 XYZ shares at $40 each. However, her long call is in-the-money as well, which means she can buy those same shares for $55 each. Her net loss for each share is $15, or $1,500 total. This is offset by the premium she received, reducing her maximum potential loss to $910.

 If the stock price falls below $40 at expiration:

Both of Investor A’s options expire out-of-the-money, and she keeps the $590 for the maximum profit.

 If the stock price rises to $60 at expiration:

Investor B’s short call is in-the-money, and he must sell 100 XYZ shares at $40 each, for a total loss of $2,000 over their market price. His credit offsets this by $720, reducing his maximum potential loss to $1,280.

 If the stock price falls below $40 at expiration:

Investor B’s option expires out-of-the-money, and he keeps his entire $720.

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Each options transaction is known as a leg of the overall strategy, and most options spreads stand on two legs — though there are some strategies with three or more legs.

What are the benefits?

Many options investors use spreads because they offer a double hedge, which means that both profit and loss are limited. Investors who are interested in more aggressive options strategies that might expose them to significant potential losses can hedge those risks by making them one leg of a spread. The trade-off is that the potential profit is limited as well. It might help to think of spreads as a form of self-defense. Just as you can open an options position to protect against losses in a stock position, you can open an options position to protect against losses in another options position.

Credit or debit?

If, like Investor A, you receive more money for the option you write than you pay for the option you buy, you’ve opened a credit spread. The difference between the two premiums is a credit you receive, and it will be deposited in your brokerage account when you open the position. In most cases, the goal of a credit spread is to have both options expire worthless, retaining your credit as profit from the transaction.

If you pay more for your long option than you receive for your short option, you’re taking on a debit spread. You’ll have to pay your brokerage firm the difference between the two premiums when you open the transaction. In most cases, the goal of a debit spread is to have the stock move beyond the strike price of the short option so that you realize the maximum value of the spread.

Credit spread:
premium you receive > premium you pay
Debit spread:
premium you receive < premium you pay

Are you qualified?

Although spreads aren’t always speculative or aggressive, they are complex strategies that aren’t appropriate for all investors. Your brokerage firm may have its own approval levels for debit spreads and credit spreads, to ensure that you’re financially qualified and have adequate investing experience. Additionally, managing spreads as expiration nears requires time and attention, so you should be sure you want to take on the challenge.

More types of spreads

A Calendar spread is the purchase of one option and writing of another with a different expiration date, rather than with a different strike price. This is usually a neutral strategy.

A straddle is the purchase or writing of both a call and a put on an underlying instrument with the same strike price and the same expiration date. A buyer expects the underlying stock to move significantly, but isn’t sure about the direction. A seller, on the other hand, hopes that the underlying price remains stable at the strike price.

A strangle is the purchase or writing of a call and a put with the same expiration date and different — but both out-of-the-money — strike prices. A strangle holder hopes for a large move in either direction, and a strangle writer hopes for no significant move in either direction.

Steps of executing a strategy

The first step in executing a spread is choosing underlying security on which to purchase and write the options.

2. Next, you’ll have to choose the strike prices and expiration dates that you think will be profitable. That means calculating how far you think a stock will move in a particular direction, as well as how long it will take to do so.

3. You should be sure to calculate the maximum profit and maximum loss for your strategy, as well as the circumstances under which you might experience them. Having realistic expectations is essential to smart options investing.

4. Finally, you’ll have to make the transactions through a margin account with your brokerage firm. The minimum margin requirement for a spread is usually the difference between the two strike prices times the number of shares covered.

How To Profit With Options Spread Strategies? by Inna Rosputnia

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