Option Spreads: Tips And Things To Consider
  1. Option Spreads: Introduction
  2. Option Spreads: Selling And Buying To Form A Spread
  3. Option Spreads: Vertical Spreads
  4. Option Spreads: Debit Spreads Structure
  5. Option Spreads: Credit Spreads Structure
  6. Option Spreads: Horizontal Spreads
  7. Option Spreads: Diagonal Spreads
  8. Option Spreads: Tips And Things To Consider
  9. Options Spreads: Conclusion

Option Spreads: Tips And Things To Consider


By John Summa, CTA, PhD, Founder of OptionsNerd.com

Now that you have obtained a solid foundation for underlying option spreads, here are some tips on how to use them. In this section, we'll focus on the use of orders, liquidity and some margin-related matters.


Spread trades, as a rule, should be established using a spread order, leaving legging into the spread (placing one leg at a time) to the pros. The possibility of having the market move against you while trying to leg in makes using spread orders imperative. But what type of spread orders should you use? Generally speaking, you should always work a spread order using a limit price to assure you get the desired price that will make the spread work out according to plan. For example, because there is a limited profit potential in many spreads, it is essential to get filled correctly, or not to get filled at all. Limit orders serve this purpose well.

In today's online trading environment, simple spreads can be placed with limit orders and filled without too much trouble. Of course, it is important to make sure the option strikes comprising the spread have enough liquidity, measured in open interest and daily volume. The options should have at least a few hundred options traded (on average) daily with at least as much open interest if you are doing spreads that may require removal of the spread when it gets into trouble, or the execution of adjustments.

If you simply plan to hold a debit spread (buying spreads) until expiration, then liquidity is not as important. However, be aware that the more liquid the market, the better the pricing. With little liquidity, the market makers tend to widen the bid-ask spreads, making achieving your profit objectives more difficult. Always examine option prices for a few days to get an idea of how they are being priced if you are not sure about what size the bid-ask should be. You can also compare the bid-ask spreads across stocks of similar price (but different liquidity) to evaluate how wide the market is.

In most of the spreads presented in this tutorial, margin requirements are straightforward. For example, if you were to sell a vertical credit spread like the IBM call credit spread presented in the previous section using the strikes that are five points apart, the margin on the account would be the size of the spread minus the premium collected. In this case, since we collected $120 in premium, the margin requirement would be $500-$120=$380. If we were to retain the entire premium collected as profit, the rate of profit on the required (and maximum margin) would be 24% (abstracting from commissions).

For debit spreads, the capital required to open the position is always the cost of buying the spread. All debit spreads are strategies that are bought, so there must be enough capital in the account to pay for the spread.




For diagonal spreads, the margin story is not quite as simple. If the spread is established in a futures options market, a margin system known as SPAN applies. SPAN margin offers the advantage of having the nearby short option in a diagonal call or put credit spread looked at as a covered option. In most equity options brokerage accounts, the short leg across months is margined as a naked option, which can significantly impact overall performance due to the extra margin that is required to trade the strategy.

Finally, when applying horizontal and diagonal spreads to futures options, you may be trading two underlying contracts. For example, an S&P 500 futures options June-September diagonal put spread would have the June trading on the June futures and the September option trading on the September futures contract. It is not a big issue really, but something to be aware of if you decide to explore options on futures as an additional arena for applying options spreads.

Options Spreads: Conclusion

  1. Option Spreads: Introduction
  2. Option Spreads: Selling And Buying To Form A Spread
  3. Option Spreads: Vertical Spreads
  4. Option Spreads: Debit Spreads Structure
  5. Option Spreads: Credit Spreads Structure
  6. Option Spreads: Horizontal Spreads
  7. Option Spreads: Diagonal Spreads
  8. Option Spreads: Tips And Things To Consider
  9. Options Spreads: Conclusion
RELATED TERMS
  1. Long Leg

    The part of an option spread strategy that involves buying an ...
  2. Buy A Spread

    Option strategy that will be profitable if the underlying security ...
  3. Short Leg

    Any contract in an option spread in which an individual holds ...
  4. Credit Spread Option

    A financial derivative contract that transfers credit risk from ...
  5. Diagonal Spread

    An options strategy established by simultaneously entering into ...
  6. Spread Indicator

    An indicator that shows the difference between the bid and ask ...
RELATED FAQS
  1. What's the difference between a credit spread and a debt spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
  2. How do I set a strike price in an options spread?

    Find out more about option spread strategies, and how to set the strike prices for bull call spreads and bull put spreads ... Read Answer >>
  3. What is the average debt/equity ratio for the Internet sector?

    Learn about how debit option spreads work, including their maximum profit and loss, and understand how time decay impacts ... Read Answer >>
  4. What types of stocks have a large difference between bid and ask prices?

    Find out which factors influence bid-ask spread width. Learn why some stocks have large spreads between bid and ask prices, ... Read Answer >>
  5. What is spread hedging?

    Learn about one of the most common risk-management strategies options traders use, called spread hedging, to limit exposure ... Read Answer >>
  6. How do traders use debit spreads to protect against loss?

    Review an example of how a trader might use a debit spread to limit the maximum loss on an options transaction, limiting ... Read Answer >>

You May Also Like

Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center