Wednesday, 8th September 2010

An Introduction to Spreads

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
February 11, 2010

Why use spreads:

  • To profit on the movement in a stock while capping your potential loss at a pre-determined amount — though you cap your potential profit as well.
  • To purchase options with less cash up-front, which in turn helps leverage your potential returns.
  • To earn sizable percentage gains even on modest moves in the underlying stock.

A spread is an option position in which you both buy (“buy to open”) and write (“sell to open”) options of the same type, usually with the same expiration date, on the same stock. The payment from the options you write helps offset the cost of the options you buy, limiting your initial cost. At the same time, the options — being opposites, because they’re both bought and written — counterbalance one another, capping your risk.

For example, you might write a call at one strike price and use the proceeds to buy a call at a lower strike price (with the same expiration date, on the same stock). This is called a “bull call” spread; your maximum potential profit is the difference between the strike prices, minus the net cost to initiate the trades. Because one option covers the risk in the other, your maximum loss is the amount you pay to set up the trade.

Why the name “spreads”? It refers to the difference between the two options’ strike prices, which largely determines your potential profit. But spreads don’t always use different strike prices, so the name may sometimes refer to the difference between the two options’ prices.

The Common Spreads

No matter what kind of spread we’re setting up, usually we’ll aim for at least a 50% return — ideally, 100% or more — to make the risk, which is a full loss of the investment, worthwhile. Here are some of the spreads you’ll encounter most often:

Bull call spread: A bullish strategy in which you write a call with a higher strike price (usually above the underlying stock’s current price) and buy a call with a lower strike price. You earn the full potential profit if the stock increases above the higher strike by expiration; you lose the full investment if the stock falls below the lower strike by expiration.

Bull put spread: A bullish strategy, even though it uses puts; you purchase lower-strike puts and write higher-strike puts, for a net credit. If the stock ends above the higher strike at expiration, you earn the maximum profit.

Bear put spread: A bearish strategy in which you write a put with a lower strike price (usually below the stock’s current price) to buy a put with a higher strike price. You earn the full profit if the stock declines below the lower strike by expiration; you lose your full investment if the stock increases above the higher strike by expiration.

Bear call spread: A bearish strategy that uses calls; you purchase higher-strike calls and write lower-strike calls, earning the full profit if the stock ends below the lower strike at expiration. Bear put spreads are generally superior to bear call spreads if you’re exceptionally bearish, but bear call spreads are attractive because they start with a credit and can use less buying power.

Butterfly spread: This neutral strategy combines a bull spread with a bear spread (there are four possible ways to set it up); you profit most if the underlying stock does not rise or fall much by expiration. Like all spreads, it has limited risk and limited profit potential.

Calendar spread: A generally neutral strategy in which you write a nearer-term option and purchase the same option (in this case, at the same strike price) but with a much later expiration date. Time erosion should cause the value of the nearer-term option (which you wrote) to decay more quickly than the longer-term option that you bought; if it works as intended, you’ll show an overall profit as the near-term option reaches expiration.

Ratio spreads: Also a generally neutral strategy, here you buy a certain number of calls (called a ratio call spread) or puts (called a ratio put spread) and then write a larger number of calls or puts (say, two for every one you’ve bought) that are out-of-the money. Your profit is maximized if the stock ends exactly at the strike price of the written options. Ratio spreads have increased risk because not all of your written options are “covered” by purchased options.

We’ll get into these and other spreads in greater detail in future Pro guides; for this introduction, we just want you to become familiar with the many terms and basics behind spread strategies. And — if you need to — you can take this opportunity to apply for approval to use spreads at your broker (it’s usually Level 4).

Learn the Language of Spreads

When setting up a spread trade, the combined premiums are labeled like so:

  • Debit spread, or net debit: Here, you pay more in premiums to set up the spread than you collect.
  • Credit spread, or net credit: Much less common than a net debit, in this case, the spread’s total option premiums collected pay you more than you need to pay out. In other words, the options you write pay you more than you need to shell out to buy the other options to complete your spread.
  • Spread order: This kind of special order allows you to make two or more options trades (usually for a lower commission) with your broker at the same time — thus setting up your spread. Usually, the trade is entered as a limit order at the maximum net debit you’re willing to pay or the minimum net credit you want to receive. This is similar to using a limit price when trading a stock.

Moreover, spreads can be described more precisely depending on where the strike prices and expiration dates fall:

  • Vertical spreads: The most common spreads fit this description, including basic bull and bear spreads. In a vertical spread, the options have different strike prices but the same expiration date. It’s called “vertical” because the strike prices are above and below one another in an option-quote chain.
  • Horizontal spreads: In this case, the options have the same strike price (so they’re horizontal to one another in a quote chain) but different expiration dates.
  • Diagonal spreads: Here, the options you buy have a later expiration date than the options you write, along with a different strike price. You can set up diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads, to name a few. We’ll address why and how in later guides.

Now let’s illustrate what we’ve covered so far with a real-life (OK, a very fake) example.

A Vertical Bear Put Spread in Action

As the result of a questionable federal government-backed merger, a new company comes into existence called Fannie Madoff (Nasdaq: FMAD). Most investors are optimistic, pointing out that anything the Fed does, it does well, so they’re sure the firm will be a resounding success.

You, on the other hand, are fairly certain this house of cards will topple. The company has questionable management and is crippled with debt — yet investors continue to bid the stock higher. Since you don’t want to risk your net worth going short, you set up a bear put spread, limiting your potential losses.

With the stock trading at $34, to set up a bear put spread, you could write $32.50 puts for a $1.50 payment and use the proceeds to buy $35 puts for $2.50. Your net debit is $1 per share. That’s the most you can lose. How much can you make if Fannie Madoff faces the music? Since the difference between your strike prices is $2.50, and the trade cost you $1, the most you can make is the difference between the two, or $1.50 per share. That’s great, given that you only paid $1 to set up the trade. It’s a potential 150% return on your investment.

What are the possible outcomes? If the stock falls anywhere below $32.50 by expiration, you capture the maximum gain. For example, let’s say it falls to $30. The $35 puts you bought will be worth $5 per share, while the $32.50 puts you wrote will be worth ($2.50). You hold a net $2.50 profit following your $1 net investment, so you’ve cleared $1.50 per share while only risking $1.

On the flipside, if the Fed gives our fake Fannie another boost, and the stock is above $35 at expiration, your whole investment is lost — but at least you only paid a net $1 per share. Other possible outcomes: If the stock trades at various price points between the two strikes, you’ll have either a partial profit or partial loss when you exit the trade at expiration. (When to close a spread early is a topic for another day.) This is the essence of how a spread works: You limit your risk while potentially earning a large — though capped — percentage return on a lower out-of-pocket cost.

Spreads Ahead

To sum up, spreads involve both buying and writing the same type of option on the same stock, usually with different strike prices, while aiming to profit on the difference in strike price, after your net cost, between the two. Your maximum profit is capped to these price differences, and your maximum loss is the net debit that it takes to set up the trade.

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