In a series of recent articles on stockinvestor.com, I explained some basics of option spread trading. If you are new to option spread trading, I suggest that you read these articles before moving on to specific details on individual option spread strategies.
I will outline many different options spread strategies. The huge number of strategies might seem intimidating at first. Don’t worry. I will explain which ones to use if our approach is bullish, bearish or neutral. Knowing which approach to use makes navigating complex option spread strategies simple.
Types of Spread Strategies
There are three basic types of option spread strategies — vertical spread, horizontal spread and diagonal spread. These names come from the relationship between the strike price and the expiration dates of all options involved in the specific trade. Some of the more complicated strategies include intermarket, exchange and delivery spreads, intercommodity and commodity spreads.
I will mention briefly some of those more complicated strategies. However, the key is that we do not need complicated spread strategies to trade successfully in the options market. Understanding these complex strategies requires a significant amount of research and analysis. However, unless you understand option markets well, the advantage gained might not be worth the additional effort.
Therefore, I will focus on explaining the basic option spread trades. For now, we will forget about intermarket, intrasecurity, and cross-commodity spreads beyond their basic definition.
Vertical spread refers to moving up or down the pricing list to find differently priced options in the same expiration month and with the same underlying security. Anyone familiar with online options pricing knows how to go up and down to find differently priced options. This process is identical for calls and puts.
Horizontal spread refers to moving along the expiration date at the same price level.
Diagonal spread refers to moving along both the strike price and the expiration date.
Source Yahoo! Finance. This table of a GOOGL option price chart for February 3, 2016, shows puts priced in the $865 to $875 range. The date range is different from GOOGL pricing examples used in some other articles.
Often, option prices will have the calls on one side of the strike price and the puts on the other side. To engage in a vertical spread, I would buy an $865 put and sell an $875 put. Those options are shown in the image above.
For a horizontal spread, I would buy an $875 February put and perhaps sell an $875 March put. The horizontal part of that trade comes from moving from February to March or any other month past February.
The diagonal spread trade would be buying an $865 February put and perhaps selling an $875 March put or buying an $875 March call or selling an $865 February put. It is not important whether I buy or sell a put or a call. The important aspect is that I have crossed into a new month and I have selected a new price.
Options spread strategies are known often by more specific terms than three basic types. Some of the names for options spread strategies are terms such as bull calendar spread, collar, diagonal bull-call spread, strangle, condor and a host of other strange-sounding names.
Intermarket and intercommodity option trading
Intermarket option spread trading or interexchange option spread trading refers to trading options across different markets and exchanges. This type of option trading is sometimes also a form of arbitrage for price discrepancies across different markets.
Intercommodity option spread trading involves trading options based on different underlying commodities. Someone can buy a natural gas future and sell a crude oil future or buy a natural gas option on futures and sell crude oil options on futures. A disadvantage of intercommodity option trading is the increased option pricing complexity. Additionally, I also must become an expert in two separate markets very quickly when I engage in intercommodity trading.
We can apply any of the tools and strategies I discuss to all different kinds of trades. However, the more complex trading strategies are usually only beneficial if you have exhausted all alternative trading and investing strategies. To keep things simple, I will not get involved with cross-market, cross-commodity, or cross-exchange trades.
My focus is on intermarket and delivery spread trading. This type of trading is relatively simple to execute. It focuses on a particular security and demands changing only the strike price or the exercise date.
I will provide full explanations and detailed guidance only for the low-risk options spread strategies. To offer a complete account of available option spread strategies, I will provide basic definitions for the high-risk strategies as well. Please note that I generally do not recommend these high-risk options as viable strategies for novice and average option traders.
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.