What Is an Alligator Spread?
An alligator spread is a trading position that is destined to be unprofitable from the start because of the onerous fees and transaction costs associated with it. The term is often used in relation to the options market, where investors sometimes combine various put and call options to form complicated positions. Each leg of the spread may come with its own set of trading costs.
If the fees from these transactions become too large, the investor might lose money on the transaction, even if the market moves in an otherwise profitable direction. In such cases, the potential profits are "eaten" by fees, like an alligator.
- An alligator spread is a trading strategy where any opportunity for profit has been erased by fees and trading costs.
- The term is often used in options trading, where multi-leg spreads and other complex trading strategies can involve high costs to put on and take off the position.
- Although unscrupulous brokers might sometimes sell investors on alligator spread positions, these situations most commonly arise by accident.
- To avoid them, investors must carefully review all the fees associated with their positions, including the costs involved with exiting a position.
What's an Alligator Spread?
Understanding Alligator Spreads
Investors usually use the term "alligator spread" when referring to trades made in the options market, especially in relation to complicated positions involving put and call options. These types of trades are designed to profit from the movement of an underlying asset within a particular range.
For instance, an investor might profit if a stock appreciates or depreciates by up to 20% in either direction. In that scenario, the investor faces a relatively narrow window within which to profit on the position; if the various fees associated with that position are too costly, it may be impossible for them to realize a profit on an after-fees basis, even if the security moves in a favorable direction.
In theory, investors can avoid this problem by carefully reviewing the fees associated with the investment position they are considering. However, this can be difficult to do in practice, as there can be many different kinds of fees involved. These include brokers' commissions, exchange fees, clearing fees, margin interest, and fees associated with exercising options. Other issues, such as tax implications and bid-ask spreads, can also eat into profits. Considering that investors in these markets are already dealing in fairly complicated transactions, it is understandable that they might fail to realize that they have created an alligator spread—until it is too late.
Although competition has tended to lower commissions and other fees over time, investors should still carefully review their brokers' fee schedules to avoid having their profits devoured by an alligator spread.
Real World Example of an Alligator Spread
Charlie is an options trader who is considering opening a position with shares in XYZ Corporation as the underlying asset. Presently, XYZ is trading at $20 per share, but Charlie expects the shares to experience greater volatility over the next six months. Specifically, he thinks there is a good chance that XYZ shares will either rise to $30 or decline to $10 over that timeframe.
To profit from this anticipated volatility, Charlie purchases a call option that expires in six months and has a strike price of $25. To obtain this option, he pays a $2 premium.
Although this call option allows him to profit if XYZ's share price increases, Charlie wants to position himself so that he profits on increased volatility regardless of whether the price moves up or down. To that end, he purchases a second option, this one a put option which expires in six months and has a strike price of $15 per share. To obtain it, he pays another $2 premium.
Looking at his position, Charlie feels he has accomplished his goal. If the price moves up to $30, he can exercise his call option and net a profit of $5 per share (buying for the exercise price of $25, and then selling for the market price of $30). Since each option represents a lot size of 100 shares, that works out to a $500 profit. If on the other hand prices decline to $10, he can exercise his put option and also net a $5 per share profit (buying for the market price of $10, and then selling at the exercise price of $15).
Although Charlie's position looks sound on paper, it has one crucial flaw. Charlie failed to keep track of his transaction fees. After accounting for his premium payments, his broker's commissions, his tax liability, and various other costs, Charlie discovers that these expenses will total over $5 per share. Charlie, in other words, has stumbled into an alligator spread—due to the high costs of his position, he is unable to make money even if he is correct in his prediction about XYZ.