Option Spread a Defined Risk Strategy Explained

Option Spreads explained

Most traders start with buying options. It is easy to understand. But professionals know that the odds are in your favor if you selling options.

Traders that start out selling options by shorting out of the money calls or puts. They do so because they collect option premium and they know that many options expire worthless.

But sometimes the stock takes an unexpected move and the seller is risking to loose a lot of money. If you do not like the risk of naked options what alternative do you have?.

Option Spreads is a defined risk strategy. This maximum risk is defined by the width of the strikes. If the stock moves in your favor you can keep the premium. If it moves against you you only have a limited loss.

Selling Option Spreads

With the majority of options expiring worthless, many traders are interested in selling options. Options are a wasting asset. With no change in any of the underlying assumptions, an option will lose part of its value everyday until the option expires worthless.

Time only moves in one direction, so an option seller benefits from the effects of time decay everyday. The option seller, however, must protect against a large adverse price move, as well as an increase in implied volatility.

Many traders start out selling premium by selling out of the money calls or puts, sometimes both at the same time. In other words they are entering a naked position. Statistically speaking, this can be a profitable strategy, as the majority of out of the money options will expire worthless. The problem comes when the underlying market makes a large move in one direction and months of profitable trades are erased. To elude the risk you do not sell a naked option but sell an spread instead. In this way you can only loose the difference between the strike minus the credit received.
Option Spread Strategies

Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

The three main types of spreads are the vertical spread, calendar spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved.

Vertical spreads are spreads involving options of the same underlying security, expire in the same month, but have different strike prices. If you enter a position and you receive a credit than we talk about a credit spread. If you payed to set up the position then you entered a debit spread. We use credit spreads with options with high implied volatility and debit spreads with options of low IVR.

Calendar spreads are created using options of the same underlying security, same strike prices but with different expiration dates.

Diagonal spreads are constructed using options of the same underlying security but with different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.




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