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.

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