2 Easy Option Spread Strategies for Minimizing Risk

Billy Williams

option spread strategies

Option spread strategies are simultaneous purchases and sales of the same class option on the same basic security but with different expiration dates or with a different strike price. Let us use the example of Class C share price of Alphabet, Inc. (NASDAQ: GOOGL) from an article to explain.

The Alphabet, Inc. is trading stock traded around $1,275 per share in 2020 but it went for about $800 per share in October 2016. Instead of just buying an out-of-the-money call option on Alphabet, Inc. at a slightly higher price than where it currently trades, suppose I want to engage in a spread option trade to reduce risk and protect my investment.

Bull Call Spread

A bull call spread means that I will buy one in-the-money call option, and I will sell one out-of-the-money call option. This is generally a good strategy to take advantage of an asset’s share price increasing moderately over a few months.

Let’s imagine our chosen stock’s share price traded around $800. I could enter a bull call spread by buying a call that is already in the money (ITM). This means that the strike price — $760 per share for example — is lower than the share price of $800. At the same time, I would write a call for the same expiration date that is out of the money (OTM) with a strike price around $825.

The in-the-money call should cost me approximately $55, while the out-of-the-money call will make me about $20. My debit for entering this trade is $55 minus $20, which equals $35. These prices are per each share. Option contracts are generally written for 100 shares. Therefore, my total debit at the beginning of this strategy will be $3,500.

Exclusive  The Collar Option Strategy – What is it?

I will address methods for picking strike prices and expiration dates at another time. At this point, it is important that you understand how option spreads look, what some of the costs and benefits are, and why you should use option spreads. The main advantage of the bull call spread is that I have reduced my expense in buying a call by selling a call that is out of the money.

You might notice that I have also reduced my potential upside relative to buying a simple call option. That is absolutely correct. However, with option spread trading, my goal is not to extract the highest gain possible on just the successful trades. Option spread trading is a long-term strategy with a goal to reduce my risk and increase the likelihood of profit on every single trade.

Bear call spread

What If I believe that share prices of a stock have risen too far, too fast, and it could be ready to drop? This is a bearish stance, and I want to go short on the stock options. In this case, I will use a bear call spread.  One major benefit of the bear call spread is that it immediately puts money in my pocket. When I engage in a bear call spread, I buy one out-of-the-money call, and I sell one in-the-money call.

Selling the in-the-money call might seem alarming. A trader who buys the in-the-money-call could ask immediately to exercise the option. While that is true, there is a premium for buying the in-the-money option. Therefore, the likelihood that the option will be exercised immediately is low, though it must be considered.

Exclusive  The Collar Option Strategy – What is it?

The expectation for this bear spread option strategy is that the underlying security is on the way down.  Therefore, both call options will expire worthless. This allows me to pocket the entire payment for selling the call.

Bear call spread example

Let us take another look at our example. If our chosen stock’s shares trading at $800 in October, I could decide to sell a November call with a $770 strike price for $30. At the same time, I buy a November call at a $820 strike price for $15. My net credit for entering this trade is $15. The best outcome would be if my assumptions are correct and the stock’s share price drops below the lower of the two strike prices — $770 in this example.  In that case, all options expire worthless and I get to keep the $15 credit.

If my assumptions are incorrect and the stock price increases, I will lose money on the trade.  Let us assume that the share price increases to $850. In that case, both calls will expire in the money. The call at $820 would have an intrinsic value of $50.  The call I sold at the $770 strike price would have an intrinsic value of $80. The spread between these two options is a loss of $30. However, I get to keep the $15 credit for entering the trade. That reduces my net loss to $15 per share on the trade — $1,500 for the full contract of 100 shares.

These two option spread strategies give you a basic idea of what you can accomplish with option spread trading.  These strategies do limit the profit potential on each individual trade. But, option spread trading also limits the downside and minimizes loss risk. The main objective of option spread trading is to generate sustainable profit with minimum risk.

Exclusive  The Collar Option Strategy – What is it?

———-

Billy WIliams option spread strategies

Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.

Like This Article?
Now Get Mark's FREE Special Report:
3 Dividend Plays with Sky-High Returns

This newly-released report by a top-20 living economist details three investments that are your best bets for income and appreciation for the rest of the year and beyond.

Get Access to the Report, 100% FREE


img
previous article

Last week was mostly negative for global stock markets, with the Dow Jones up 0.09%, S&P 500 down 0.69% and NASDAQ falling 1.28%. The MSCI Emerging Markets Index also fell 1.78%. Big gainers in your Bull Market Alert portfolio included Littelfuse (LFUS), which rocketed 10.10%; LogMeIn (LOGM), which climbed 4.43%; and Cirrus Logic, Inc. (CRUS), which rose 2.50%. Both Littelfuse (LFUS) and LogMeIn (LOGM)

PREMIUM SERVICES FOR INVESTORS

Dr. Mark Skousen

Named one of the "Top 20 Living Economists," Dr. Skousen is a professional economist, investment expert, university professor, and author of more than 25 books.

Product Details

LEARN MORE HERE

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Product Details

LEARN MORE HERE

Jim Woods

Jim Woods has over 20 years of experience in the markets from working as a stockbroker,
financial journalist, and money manager. As well as a book author and regular contributor to
numerous investment websites, Jim is the editor of:

Product Details

LEARN MORE HERE

Bob Carlson

Bob Carlson provides independent, objective research covering all the financial issues of retirement and retirement planning. In addition, Bob serves as Chairman of the Board of Trustees of the Fairfax County (VA) Employees’ Retirement System, which has over $2.8 billion in assets.

Product Details

LEARN MORE HERE

Hilary Kramer

Hilary Kramer is an investment analyst and portfolio manager with 30 years of experience on Wall Street. Since 2010, Hilary's financial publications have provided stock analysis and investment advice to her subscribers:

Product Details

LEARN MORE HERE

Jon Johnson

Jon Johnson's philosophy in investing and trading is to take what the market gives you regardless if that is to the upside or downside. For the past 21 years, Jon has helped thousands of clients gain success in the financial markets through his newsletters and education services:

Product Details

LEARN MORE HERE

DividendInvestor.com

Used by financial advisors and individual investors all over the world, DividendInvestor.com is the premier provider and one-stop shop for dividend information and research.

Product Details

Popular tools include our proprietary Dividend Calendar, Dividend Calculator, Dividend Score Card, and many more.

LEARN MORE HERE