Understanding
Stock Options Trading
and Technical Analysis Basics

Spread Options and Spread Trading

Spread option trading is a technique that can be used to profit in bullish, neutral or bearish conditions. It basically functions to limit risk at the cost of limiting profit as well. Spread trading is defined as opening a position by buying and selling the same type of option (ie. Call or Put) at the same time. For example, if you buy a call option for stock XYZ, and sell another call option for XYZ, you are in fact spread trading.

By buying one option and selling another, you limit your risk, since you know the exact difference in either the expiration date or strike price (or both) between the two options. This difference is known as the spread, hence the name of this spread treading technique.

Summary:

Spread trading is carried out by buying an option, and selling an option of the same type for the same stock. This technique limits your risk, since you know the spread between the two options. However, profits are limited as well.

Various strategies can be carried out using this technique. The main ones are vertical spreads, horizontal spreads and diagonal spreads.

A Vertical Spread is a spread option where the 2 options (the one you bought, and the one you sold) have the same expiration date, but differ only in strike price. For example, if you bought a $60 June Call option and sold a $70 June Call option, you have created a Vertical Spread.

Let's take a look at why you would do this. Let's assume we have a stock XYZ that's currently priced at $50. We think the stock will rise. However, we don't think the rise will be substantial, maybe just a movement of $5.

We then initiate a Vertical Spread on this stock. We Buy a $50 Call option, and Sell a $55 Call option. Let's assume that the $50 Call has a premium of $1 (since it's just In-The-Money), and the $55 Call has a premium of $0.25 (since it's $5 Out-Of-The-Money). So we pay $1 for the $50 Call, and earn $0.25 off the $55 Call, giving us a total cost of $0.75.

Two things can happen. The stock can either rise, as predicted, or drop below the current price. Let's look at the 2 scenarios:

Scenario 1: The price has dropped to $45. We have made a mistake and predicted the wrong price movement. However, since both Calls are Out-Of-The-Money and will expire worthless, we don't have to do anything to Close the Position. Our loss would be the $0.75 we spent on this spread trading exercise.

Scenario 2: The price has risen to $55. The $50 Call is now $5 In-The-Money and has a premium of $6. The $55 Call is now just In-The-Money and has a premium of $1. We can't just wait till expiration date, because we sold a Call that's not covered by stocks we own (ie. a Naked Call). We therefore need to Close our Position before expiration.

So we need to sell the $50 Call which we bought earlier, and buy back the $55 Call that we sold earlier. So we sell the $50 Call for $6, and buy the $55 Call back for $1. This transaction has earned us $5, resulting in a nett gain of $4.25, taking into account the $0.75 we spent earlier.

What happens if the price of the stock jumps to $60 instead? Here's where the - limited risk / limited profit - expression comes in. At a current price of $60, the $50 Call would be $10 In-The-Money and would have a premium of $11. The $55 Call would be $5 In-The-Money and would have a premium of $6. Closing the position will still give us $5, and still give us a nett gain of $4.25.

In tabular format:

Resulting stock price $45 $50 $55 $60
Premium of $50 Call --- $1 $6 $11
Premium of $55 Call --- $0.25 $1 $6
Difference in premium --- $0.75 $5 $5
Initial cost $0.75 $0.75 $0.75 $0.75
Total profit -$0.75 $0 $4.25 $4.25

Once both Calls are In-The-Money, our profit will always be limited by the difference between the strike prices of the 2 Calls, minus the amount we paid at the start. As a general rule, once the stock value goes above the lower Call (the $50 Call in this example), we start to earn profit. And when it goes above the higher Call (the $55 Call in this example), we reach our maximum profit.

So why would we want to perform this spread option? If we had just done a simple Call option, we would have had to spend the $1 required to buy the $50 Call. In this spread trading exercise, we only had to spend $0.75, hence the - limited risk - expression. So you are risking less, but you will also profit less, since any price movement beyond the higher Call will not earn you any more profit. Hence this strategy is suitable for moderately bullish stocks.

This particular spread we have just performed is known as a Bull Call Spread, since we performed a Call Spread with a bullish or upward-trending expectation. Similarly, Bull Put Spreads, Bear Call Spreads and Bear Put Spreads are all based on the same technique and function quite the same.

Bull Put Spreads are strategies that are also used in a bullish market. Similar to the Bull Call Spread, Bull Put Spreads will earn you limited profit in an uptrending stock. We implement Bull Put Spreads by buying a Put Option, and by selling another Put Option of a higher strike price. The Bear Spreads are similar to the Bull Spreads but work in the opposite direction. We would buy an option, then sell an option of a lower strike price, since we anticipate the stock price dropping.

Summary:

A Vertical Spread is a spread where the options you buy and sell only differ in strike price. A Bull Call Spread is a spread performed on a bullish stock. You Buy a Call at a particular strike price, and Sell a Call with a higher strike price. Breakeven occurs when the stock rises above the lower strike price, and maximum profit occurs when the stock rises above the higher strike price.

We now look a Horizontal Spreads Options. Horizontal Spreads, otherwise known as Time Spreads or Calendar Spreads, are spreads where the strike prices of the 2 options stay the same, but the expiration dates differ. To recap: Options have a Time Value associated with them. Generally, as time progresses, an option's premium loses value. In addition, the closer you get to expiration date, the faster the value drops. This spread takes advantage of this premium decay.

Let's look at an example. Let's say we are now in the middle of June. We decide to perform a Horizontal Spread on a stock. For a particular strike price, let's say the August option has a premium of $4, and the September option has a premium of $4.50. To initiate a Horizontal Spread, we would Sell the nearer option (in this case August), and buy the further option (in this case September). So we earn $4.00 from the sale and spend $4.50 on the purchase, netting us a $0.50 cost.

Let's fast-forward to the middle of August. The August option is fast approaching its expiration date, and the premium has dropped drastically, say down to $1.50. However, the September option still has another month's room, and the premium is still holding steady at $3.00. At this point, we would close the spread position. We buy back the August option for $1.50, and sell the September option for $3.00. That gives us a profit of $1.50. When we deduct our initial cost of $0.50, we are left with a profit of $1.00. That is basically how a Horizontal Spread works. The same technique can be used for Puts as well.

A Diagonal Spread Option is basically a spread where the 2 options differ in both strike price and expiration date. As can be seen, this spread contains a lot of variables. It is too complex and beyond the scope of this guide.

Summary:

A Horizontal Spread is a spread where the 2 options differ in expiration date. You Sell the Closer option, and Buy the Further option. You close the position once the Closer expiration date nears. A Diagonal Spread is a spread where both strike prices and expiration dates differ.

We hope you have enjoyed this guide, and benefited from the simpler terms we've used to describe option trading. Do note that throughout the guide, we have not taken into account additional costs such as commissions and differences in bid/ask prices. Including these would have complicated this guide more than we wanted. Just note that these costs exist and will add to your costs and lower your profits.

If you want to read up on more sophisticated strategies that involve more complex combinations of option purchases and sales, do check out our Advanced Options Strategies Guide. And if you are interested in learning about Technical Analysis and Technical Indicators, do visit our Technical Analysis Guide if you have not already done so.