A:

An alligator spread refers to a financial position (a unique combination of put and call options) that is unprofitable because of the high commission it generates. This phenomenon is called an alligator spread because the position is said to "eat alive" whatever profit the investor makes from the position. This spread is only seen with financial advisors or brokers that work on a commission basis. The unprofitability of the position is not necessarily caused by market effects but by the commission of the intermediary brokering the transaction.

The unique blend of put and call options that help to set up an alligator spread can result in commission that can be so high that most of any realized profits end up going to the broker and the investor realizes next to nothing from the deal. For example, if the executed position makes a profit of $2000, the commission might be between $1000 and $1500, thereby wiping out the profit and netting the investor next to nothing.

It is very possible for a broker to intentionally arrange a put and call option combination that results in an alligator spread, but for the most part, an alligator spread happens randomly. One way of dealing with an alligator spread is for the investor to look at the commission schedule for the broker or financial advisor and be aware of the commission levels for certain put and call positions. Another way of trying to prevent alligator spreads is for the investor and the broker to pay careful attention to the sequence of call and put options being paired and what the consequences or possible results of the pairing will be.

To learn more about commissions, and how they can affect quality of service, be sure to check out our related article Paying Your Investment Advisor - Fees Or Commissions?

This question was answered by Chizoba Morah.

RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
Related Articles
  1. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  2. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  3. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  4. Term

    What is Pegging?

    Pegging refers to the practice of fixing one country's currency to that of another country. It also describes a practice in which investors avoid purchasing security shares underlying a put option.
  5. Home & Auto

    Understanding Pre-Qualification Vs. Pre-Approval

    Contrary to popular belief, being pre-qualified for a mortgage doesn’t mean you’re pre-approved for a home loan.
  6. Investing Basics

    An Introduction To Structured Products

    Structured products take a traditional security and replace its usual payment features with a non-traditional payoff.
  7. Options & Futures

    Contango Versus Normal Backwardation

    It’s important for both hedgers and speculators to know whether the commodity futures markets are in contango or normal backwardation.
  8. Investing Basics

    What Does Contango Mean?

    Contango​ is when the futures price of a commodity is higher than the expected future spot price.
  9. Options & Futures

    The Short Guide To Insure Stock Market Losses

    The best ways to hedge against losses are to diversify your portfolio and to use a variety of options.
  10. Term

    How Points Relate to Financial Instruments

    Points usually refer to the measurement of some change in a financial instrument’s value.
RELATED TERMS
  1. Warrant

    A derivative that confers the right, but not the obligation, ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Bull Call Spread

    An options strategy that involves purchasing call options at ...
  4. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  5. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  6. Convergence

    The movement of the price of a futures contract towards the spot ...
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center