Options spreading is one common use of these securities and involves buying and selling options at the same time (spreading) or buying combinations of options. In this section, we will provide a very basic overview of the most common options spreads and combinations.
Long Calls and Puts
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises and your downside is limited to the option premium if it does not. If you simultaneously buy a put option with the same strike and expiration, you’ve created a straddle. This position pays off if the underlying price rises or falls; however if the price remains relatively stable, you lose both the call and the put premiums. A similar strategy is to buy a call and then also buy a put with a lower strike, known as a strangle. A strangle requires larger price moves either way to profit, but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move very much.
Spreads Bulls and Butterflies
A call spread or bull vertical spread is created by buying a call and simultaneously selling another call with a higher strike price. The spread is profitable if the underlying asset increases in price, but this upside is limited by virtue of the short call. The benefit, however, is that selling the call reduces the cost of buying the other one. Similarly, a put spread or bear vertical spread involves buying a put and selling a second put with a lower strike. If you buy and sell options with different expirations it is known as a calendar spread or time spread.
A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one). If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. An example of a butterfly would be to go long a 70 call, short two 75 calls, and long an 80 call. The identical spread could also be made with long the 70 put, short two 75 puts, and long an 80 put. Being long a butterfly profits from a quiet market. Similar to a butterfly are the condor, iron butterfly, and iron condor.
We addressed briefly how a synthetic position in the underlying can be created from options. Combining options positions with the underlying can also produce synthetic options. This has to do with what is known as put-call parity where
Call Price – Put Price = Underlying Price – Strike Price.
Rearranging this equation we can create a synthetic long call for a given strike price by buying a put and also buying the underlying. A synthetic put is likewise a long call combined with going short the underlying. Combining spreads with a trade in the underlying can also create novel positions such as the collar, fence, or risk reversal, all names for the same strategy: selling an upside call, buying a downside put, and buying the underlying.
Options Basics: Options Risks
TradingA butterfly spread is a neutral options strategy with both limited risk and limited profit potential. The strategy involves four options contracts with the same expiration month but with three ...
TradingThis relatively simple strategy is designed to provide a profit for investors who believe that there will be minimal price movement in the underlying security until expiration.
TradingLearn how long straddles, long strangles and vertical debit spreads can help you profit from the volatility that stock analysts expect for 2016.
TradingThis trading strategy is an excellent limited-risk strategy that can be used with equity as well as commodity and futures options.
TradingKnowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
TradingA bull call spread is an option strategy that involves the purchase of a call option, and the simultaneous sale of another option (on the same underlying asset) with the same expiration date ...
TradingBull spread option strategies, such as a bull call spread strategy, are hedging strategies for traders to take a bullish view while reducing risk.
TradingA bear call spread is an option strategy that involves the sale of a call option, and the simultaneous purchase of a call option (on the same underlying asset) with the same expiration date but ...