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Option Spread Strategies will help you to limit your exposure to risk and overcome the fear of losing out on your hard-earned money. Option spread strategies makes it significantly easier for the trading strategy for reaching out to the dynamic mode. Are you wondering what I am talking about?
Spread option trading is known by many of us but there are many people who clearly don’t understand the strategies. So, for you all I am here to guide you. Spread option trading is the simultaneous buying and selling of the same option. I basically know 2 types of options: call and put and I know you are too aware about it.
Basically, Spreads are composed of at least multi-leg options and further, it can be confusing sometimes. Wait! But can they be understood easily once you are well aware of the common terms?
Types of Option Spread Strategies
Are you aware of the types of option spread strategies and do you know how they can benefit you? Option Spreads are classifieds as:
- Vertical Spread Trading Option
- Horizontal Spread Trading Option
- Diagonal Spread Trading Option
- Check this also: Option Strategies: A Mentorship Program
Vertical Option Spread Strategies
Vertical Spreads are constructed that is to be used for a simple option spread. A Vertical Spread is the option strategy that involves buying and selling of put and call option. Simultaneously at a different strike price they can be sold or purchased. One needs to understand the basics of spread strategies to understand it properly.
We are going to discuss the bull call strategy because all others are based on the same technique and function alike, gende for it will be worth investing. We can also go one step forward and classify spreads that is on the basis of different outlay of the capital:
- Debit Spread Strategy: It occurs when you incur the upfront cost from the option that is further used for purchasing.
- Credit Spread Strategy: It occurs when you receive directly an upfront credit from purchasing.
Horizontal Spread Option Strategy
A horizontal spread is one of the option strategies. It is well known by the name of Calendar spread is an option or futures strategy created with simultaneous long and short positions in the derivative. The assets that are underlying at the same strike price, but with different expiration months. The strategy offers profit from changes in the volatility of the price of the underlying stock from short-term events.
Horizontal Spreads are well known as calendar Spread or the time spread because of the different expiration dates. Horizontal spreads allow traders for minimizing the effect at the time when they are trading. Futures spread using this strategy can focus on expected short-term price fluctuations. Both options and futures underlying contacts can create a de-facto position of leverage.
Diagonal Spread Option Strategy
A diagonal spread is a modified calendar spread that strikes prices. It is an option strategy established by simultaneously entering into a long and short position in two options of the same type- call options or put options.
Horizontal Spread and Diagonal Spread are of same kind i.e. Calendar Spreads. It is the advanced strategy that profits from both the decay in option prices and the differential prices.
Debit Spread Vs Credit Spread
Debit Option Spread Strategy
At the time of trading or investing in the options, there are several option spread strategies that one could spread being the purchase and sale of different options on the same underlying as a package.
While we can classify spreads in various other ways, the most common dimension is to raise a query whether or not the strategy is credit spread. Credit Spreads, or net credit spreads are spread strategies that involves the net receipts of the premiums, whereas debit spread involves net payments of premiums.
They are most commonly for beginners to option strategies that involve buying an option with the higher premium and selling it with lower one. Hence, the premium paid for the long option of the spread is more than the premium received.
You can’t compare it with a credit spread, a debit spread results with a premium debited from a trader’s or investor’s account when the position is opened. Debit Spreads are used for the costs associated with the owning long options positions.
Example: Trader A buys 1 May put option with the strike price of 20 for ₹5 and then simultaneously sell 1 May put option with the strike price of 10 and ₹1. Hence, he paid ₹4, or ₹400 for the trading purpose (if the lot size is 100). Now if the trade is out of the money, then his maximum loss will be reduced to ₹400, as opposed to ₹500 if he only bought the put option.
Credit Spread Option Strategies
A credit Spread involves the selling, or writing, a high premium option and simultaneously lower premium option. The premium that is received from the written option will be greater than the premium paid for the long options, resulting in the premium credited into the trader or investor’s account when the position is opened.
When the traders or you can say the investors uses the credit spread strategy, then the maximum profit they receive is the net premium. The credit spread results in a profit when the options spread narrow.
Example: Trader A implements a credit spread strategy by selling a call option with the strike price of 30 for ₹3 and simultaneously buying call options with 40 and ₹1. Therefore, the lot size of the underline script is 100. So the net premium received will be ₹200 for the trade. Furthermore, the trader will profit if the spread strategy narrows.
Bull Call Spread Option Strategy
A bull call spread requires the purchase at the time of money calls and the selling out of the money calls with the expiration dates. The reason for selling the out of the money calls is to help the finance at the money calls. We know that ATM calls can be fairly expensive, so this is a great method to reduce those costs.
Whereas, in the trading option, premiums are upfront fees that pay you to buy a call option. While selling a call option the investor receives the premium. So by selling the second out of the money (OTM) call option you’re basically offsetting some of the prices that are paid for the first time at the ATM call option.
Hence, premiums can be very expensive if the option strike price is closure to the current stock price.
How to profit from trading bull call options?
As the name suggests Bull call, you profit from bull call spread if they are underlying assets that will give rise in the value. The market sentiment needs to go higher.
Expert Tips: The key element of the bull call depends on the assumption that market price will be up or not.
Box Spread Option Strategy
The box Spread Option Strategy makes the advantage of price inefficiencies in option prices. When the options spreads are underpriced in relation to their expiration value for the free trading opportunities that are further created.
The box option strategy is well-known as the long box strategy. Building a box spread options involves constructing the four-legged option trading strategy or combining the vertical spread like:
- Buying a bull call spread option
- Buying a bear put spread option
Butterfly Spread Option
The butterfly spread is a neutral trading strategy that can be used when you see the low volatility with the underlying asset. The butterfly spread uses the combination of a bull spread and also a bear spread, but with three legs only. Butterfly Spread Option can be profitable but you need to understand the option.
The long call butterfly risk is limited to the premium cost you pay for opening the three-leg positions. The butterfly can also be constructed by combining and selling with a straddle and buying it with a strangle.
While stock traders need to 100% look in order to make the profit. The good thing about option spread strategies can help you to make money if you are not 100%. Yes! I mean if you are partially correct about the trades. Yeah, here the non-directional trading strategies can help you differently.
I hope now you have understood what are these Option Spread Strategies are. If you have any query related to these Option Spread Strategies can type in the comment box.
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DISCLAIMER: – we are not a SEBI research analyst. Views posted here only for educational purposes. There is no liability whatsoever for any loss arising from the use of this product or its contents. This product is not a recommendation to buy or sell, but rather a guideline to interpreting specified analysis methods. This information should only be used by investors and traders who are aware of the risk inherent in securities trading.