DEFINITION of Alligator Spread
An alligator spread is an unprofitable spread that occurs as a result of large commissions charged on the transaction, regardless of favorable market movements. An alligator spread is usually referring to trades placed in the options market to describe a collection of put and call options that may not be profitable due to the transaction costs and fees associated with establishing that position.
Options spreads involve placing trades in two or more options contracts in a way that limits downside risk, but also often limits the upside potential. Because of these bounds, options spreads have a limited range of profitability. If the cost to make the various trades necessary for the options spread are too great, they can erode the very possibility for a net profitable outcome, even if the spread itself is nominally profitable. Fees include transaction costs and commissions paid to brokers, exchange fees, clearing fees, margin costs, fees associated with the exercising of long options, and tax implications. Bid-ask spreads should also be taken into account, as wide spreads can also eat into profits.
What's an Alligator Spread?
BREAKING DOWN Alligator Spread
Options spreads are popular strategies for betting on the movement (or lack of movement) in an underlying security, involving two or more individual options contracts and limiting the potential downside risk, as well as the potential upside reward. While spreads may be popular, a trader or investor should be cognizant of the fees and costs associated with establishing such a position. Brokers typically charge a commission based on the number of options contracts traded as well as a ticket fee, for example they may charge $5 plus $1.00 per contract. So, if you buy 20 options contracts, the commission would be $25. If you leg into a 1x2 ratio put spread by selling 40 different contracts in the same underlying, the commission will grow to $70. In addition to the broker's commission, options trades typically carry additional exchange fees and clearing fees. While these fees are typically quite small - for instance, 25 cents per option for exchange fees and 5 cents per option for clearing fees - they can all add up, especially when a spread involves more than just two or three legs.
If enough fees are accumulated, an alligator spread occurs where the fees and costs eat up any chance of profitability.
Pricing models and a more efficient market can help reduce the traditional spread on a security, but it is commissions that create the alligator spread, not market inefficiencies. The commissions are dependent on a transaction's brokers. While commissions have tended to get lower over time, this is still a valid concern. Investors should check the commission schedules carefully to avoid having their profits devoured by the alligator spread.