It is not uncommon for most traders who are new to options to think of simply buying a call or put to trade. While this is not really a bad idea per se to trade this way especially if you are able to predict the direction of the underlying assets, we can actually structure the trade in a spread position to:

1. maximize reward,
2. reduce risk, and
3. lower breakeven point.

Option spread is basically a trade that involves the buying of one option and selling of another of the same type (calls or puts). There are two dimensions to spread position: Vertical or Horizontal. Vertical spread is the buying of one option and selling of another at different strikes, but within the same expiration month. Since the strikes are arranged vertically (see Figure below), it is hence called vertical spread. Horizontal spread is the buying of one option and selling of another with different expiration months, but at the same strike. Since the expiration months are arranged horizontally, it is hence called horizontal spread.

Dell Computer Option Chains

Assuming we are interested to construct a vertical spread on Dell Computer as shown in the above option chains, we shall buy and sell any two options of the same type expiring in May. For instance, we can buy and sell call options at strikes 37.50 and 40.00, which created a spread position labeled “A”. If we are interested in horizontal spread, we shall buy and sell any two options of the same type expiring in different months. For instance, we can buy and sell call options expiring in May and August at strike 40.00, which created a spread position labeled “B”.

Any combination of spread positions that resulted in a net debit to the option trader is known as Debit Spread. This option trader is a net buyer. On different token, any combination of spread positions that resulted in a net credit to the option trader is known as Credit Spread. This option trader is a net seller.

There are many ways to structure an option spread position. For purpose of meeting the scope of this article, we are only showing the four basic option spreads. They are

1. Bull Call Spread (debit spread)
2. Bear Put Spread (debit spread)
3. Bull Put Spread (credit spread)
4. Bear Call Spread (credit spread)

You may wonder why anyone would want to trade options this way. The reason is simple. Let’s take debit spread for example. If you are thinking of buying call option at strike 37.50 expiring in August, you would pay $2.50 for this trade when the stock was trading at $38.18. Now, supposing you predicted that the stock could possibly trade at $42.50 by the time it expires in August, your option would gain and be worth at $5.00 ($42.50 - $37.50). After deducting the premium paid ($2.50), that gives you $2.50 profit. This is a 100% ($2.50/$2.50) return.

Your alternative would be to trade a spread. Since you think the stock could only go as high as $42.50, you could sell the August call 42.50 for $0.50. Buying August call 37.50 and selling August call 42.50 would merely cost you $2.00 ($2.50 - $0.50) in net debit. If the stock trades at $42.50 on expiration, you would have made a gain and the August 37.50 call will be worth $5.00 ($42.50 - $37.50). After deducting the premium paid ($2.00), that gives you $3.00 in profit. This becomes a 150% ($3.00/$2.00) return.

Now imagine that the stock did not trade above $42.50, but instead fell below $37.50. In a straight call position, you would have lost a total of $2.50. On the other hand, if a spread position is taken, you would lose merely $2.00.

From the above example, you can conclude that debit spreads boost profit and reduce loss in a moderately trending situation. The limiting factor with spread position is the limited profit potential. However, since most stocks don’t go up forever, it is probably still a better trade proposition. Furthermore, time is limited, maximum profit may not be realized at all. The buyer also need not worry about fighting time value decay as in the case of straight call option.

This is a debit spread example. We shall show you the advantage of structuring a credit spread when we discuss credit spread strategy in the next article. For now, it is sufficed to say that trading with a spread position does provide you with higher reward and lower risk at the same time. As a rule of thumb, you should consider buying straight calls and puts when you expect to trade in a very short period of time – about 2 to 15 days. For trades that take between one to three months or longer, spread strategies are preferable. When buying options, you need to have as much time as possible to be right.

Deciding which one – straight or spread – to buy is really a personal judgment on the volatility of the underlying assets in the future. If the expected volatility of, say, a stock is going to be higher, you may want to opt for straight options. If it is expected to be low, debit spread is a safer bet. What I usually do is to buy straight calls or puts on stocks – especially stocks on the Nasdaq – that are expected to move quickly. I would deploy debit spreads to the mass markets such as the indexes in trending situation. Mass markets don’t move too quickly most of the times.

Learning when to use straights or spreads in different market conditions can offer you more choices to trade better and certainly help you develop as a professional trader.

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