29 Option Spread Strategies You Need to Know (Part 7)

Billy Williams

⇐ Part 6 (#17 to #21)

By Billy Williams

Six relatively little-known option spread strategies are featured below in a write-up that builds upon a previous article in an eight-part series.

This article is Part 7 and is intended to describe six option spread combinations, along with their respective risks and potential rewards. The goal is to explain how the option combinations work and give investors a realistic view of when to use these strategies and whether the possible payoff may be worth the chance of incurring losses.

22)  Long Guts

Long guts is one of my favorite option spread strategies. This strategy has unlimited profit potential and limited risk. I enter a long guts trade when I think that the underlying security’s price will have a lot of movement before my options expire. This is a debit type of spread because it does cost money to enter this trade.

I buy one in-the-money call and I buy one in-the-money put.

BUY

SELL

1 in-the-money CALL

1 in-the-money PUT

The underlying security can go way above the strike price or way below the strike price of either the call or the put. In both cases, I have unlimited profit.

I lose money when the underlying security stays within the range of the call and put. In this case, both options will expire worthless. Maximum loss is limited to my cost to enter the trade. This is a fantastic strategy for highly volatile markets.

  1. Short Guts

A short guts strategy sounds very similar to long guts. However, short guts is an entirely different strategy. It is also a strategy that I recommend avoiding. Short guts has limited profit potential and unlimited risk.

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I sell one in-the-money call and I sell one in-the-money put.

BUY

SELL

1 in-the-money CALL

1 in-the-money PUT

I have high risk exposure because I am selling options that are in the money already. If the price goes below the in-the-money put or above the in-the-money call, I face unlimited loss risk.

My profit is limited to just the credit I get when I enter this trade. For obvious reasons, this is a trading strategy to avoid.

  1. Long Call Ladder

The long call ladder is sometimes called the bull call ladder. The strategy has limited profit and unlimited risk. I use this strategy when I expect little volatility in the underlying security’s price.

I buy one in-the-money call and I sell one at-the-money call. Plus, I sell one out-of-the-money call.

BUY

SELL

1 in-the-money CALL

1 at-the-money CALL

1 out-of-the-money CALL

Whenever I sell a call or a put, I expose myself to unlimited risk. The stock price or the underlying security price might go significantly higher. The price could end up beyond the upper breakeven point or the upper call at expiration. In that case, there is no limit to how much I can lose.

My profit potential is somewhat limited in this strategy. I make money when the underlying security is somewhere between the strike prices of the call options I have sold. I make my profit because the long call ends up being worth more than the short call.

I do not recommend using the long call ladder/bull call ladder strategy.

25) Short Call Ladder     

The short call ladder is far superior to the long call ladder. This is an unlimited profit and limited risk strategy. The trades to set up this strategy are simple. I sell one in-the-money call. I buy one at-the-money call and I buy one out-of-the-money call.

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BUY

SELL

1 at-the-money CALL

1 in-the-money CALL

1 out-of-the-money CALL

This strategy works well when I expect the underlying security’s price to move a lot before the options expires.

If the underlying security’s price goes down, the long and short calls will end up worthless. But if the underlying security ends up going up much higher, the additional long call has unlimited profit potential.

The losses are limited on a short call ladder when the underlying security price is between the strike prices of the long calls on expiration. A higher long call will be worthless. The long call with the lower strike price will be worth much less than the short call.  Therefore, the result is small loss with very limited risk.

26) Long Put Ladder      

I will mention long put ladder strategy only briefly. This is another limited profit and unlimited risk strategy. I set up three trades for this strategy.

I buy one in-the-money put and I sell one at-the-money put. I also sell one out-of-the-money put.

BUY

SELL

1 in-the-money PUT

1 at-the-money PUT

1 out-of-the-money PUT

This is another strategy suited for low volatility trades. I make money when I enter the trade by selling the put options. However, the puts that I sold expose me virtually to unlimited loss potential if the price of the underlying security goes down sharply.

The unlimited loss and limited profit potential are reasons to avoid the long put ladder strategy.

27) Short Put Ladder       

The short put ladder has unlimited profit potential and limited risk. I use this strategy when I expect significant volatility.

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I sell one in-the-money put and I buy one at-the-money put. I also buy one out-of-the-money put.

All option trades are on the same underlying security and with the same expiration date.

 

BUY

SELL

1 at-the-money PUT

1 in-the-money PUT

1 out-of-the-money PUT

I make the most money when the underlying security’s price ends outside the range marked by the at-the-money and out-of-the-money puts I bought.

My profit is limited if the stock or security price goes above my upside breakeven point for the puts. The most I can earn is the amount of the initial credit for selling the in-the-money put.

However, if the price of the underlying security takes a nosedive to the downside, I have unlimited profit potential because of the two puts I purchased.

The final article in this series is Part 8 and describes option spread strategies 28 and 29.


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.

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