This is where option trading gets to be a bit more sophisticated. There are many types of spread trades that involve 2 or more options. I will cover some of the more basic spread trades here. I don’t do many spread trades, so I’ll go into one of these examples in detail and I might do the others later if there is any interest in it.
Bull Call Spread
This trade involves two call options. If you believe that a stock is either going to go up or stay relatively flat, this strategy might make sense. However, if the stock ends up going up by a large amount, you will end up limiting the gains you could have made compared to just buying a call.
In order to do a bull call spread, you first buy a call as you normally would. Then you sell a call at a higher strike price as if you are selling a covered call. You don’t actually own the stock, but since you own the call at a lower strike price, you get the same effect. If you ever get called on the short call, you can exercise your long call at a cheaper price in order to satisfy it.
For example, say a stock is currently at $42 and you expect it to close somewhere between $40 and $45 at expiration day of the month you are considering. You could buy the $40 call, say for around $4, and sell the $45 call, say for $1.50. The net cost of this spread is $4 - $1.50 = $2.50.
Let’s analyze the returns on this spread at various valuations of the stock at expiration.
- The stock closes below $40. Your short call goes down to $0 so you get to keep the $1.50 you got for it. However, your long call also goes down to $0 so you are out $4 on that. You lose the entire amount you paid for the spread, for a loss of $2.50.
- The stock closes between $40 and $42.50. Since you paid $2.50 for this spread, your break even point is at $42.50, the point at which the long call has an intrinsic value of $2.50. Anything between $40 and $42.50 gets you some amount of your money back (the value of the stock minus $40).
- The stock closes between $42.50 and $45. This is the range in which you can make profit. You paid $2.50 for the spread, so any intrinsic value in the long call above $2.50 is profit. The most you can make on this trade is $2.50. This is also the range in which this trade is more profitable than just buying a simple call, because the premium you got for the short call is added to your profits.
- The stock closes above $45. If the stock closes above $45, you can expect the short call to be exercised, assuming you held on to it until expiration. Therefore, you would exercise your long $40 call to cover the $45 short call, meaning your net profit is still $2.50. You get to keep the difference of $5 when you exercise your $40 call and then sell at $45 to cover your short call, but you paid $2.50 for this spread. In this scenario, you would have made more money if you had just bought the call.
So you can see that this trade has a very limited loss and gain potential. You stand to lose as much as $2.50 if the stock closes at $40 or less or gain as much as $2.50 if the stock closes at $45 or higher. Compared to buying a simple call, you have less money at risk but also place a cap on your profits.
Bear Call Spread
In this trade, you buy one call option then sell another call option with a lower strike price than the first. You would do a trade like this if you think the stock is going to stay flat or go down slightly. You end up with a net credit when you enter this trade, and that amount represents the most you can make if the stock closes below the lower strike price. The most you will have pay back is the difference between the strike prices, so your max loss is that value minus the amount you were credited to open the trade.
Bull Put Spread
The analysis of this trade is similar to the bull call spread. The difference is that here, you buy a put and then sell a put with a higher strike price, giving you a net credit. The credit represents the maximum you can gain on the trade, and the difference in strike prices minus the credit is the max loss.
Bear Put Spread
This trade is similar to the bear call spread. The difference is that you buy a put and sell a put with a lower strike price, for a net debit. The debit is your max loss, and the difference in strike prices minus the debit is your max gain.
Calendar Spread
This trade tries to take advantage of the diminishing time value of options. The idea is that options that are close to expiration lose their time value very rapidly, and you can profit from that by selling (shorting) the option. In order to cover your position, you would buy the same type of option with the same strike price but a later expiration date. If the stock price is relatively flat until the expiration of the near option, that option will have gone down in value but the further out option will have lost a lot less. You can then close out the trade for a profit.
