By Peter Mastrantuono
Spread options can be complex, but if an investor takes the time to learn how to employ them or partners with an experienced financial advisor, they can minimize portfolio risk and generate profits with lower market exposure.
Three Basic Spread Options…
A spread option involves the simultaneous purchase and sale of options on the same underlying security with different strike prices and/or expiration dates. There are three basic forms of spread options: Horizontal (using options with the same strike price and different expiration dates), Vertical (different strike prices but the same expiration dates) and Diagonal (different strike prices and expiration dates).
…But Many Different Expressions
The execution of these basic spread options can take on a number of different forms. For instance:
- A Bull Call Spread involves the coincident purchase of at-the-money calls and the sale of out-of the-money calls with the same expiration dates. Writing the out-of-the-money calls is done to reduce the cost of the purchase of the at-the-money calls. As its name implies, this strategy is used when an investor’s expectation is that the underlying asset will rise. The risk associated with this strategy is limited to the premiums paid and any trading fees, while the upside potential is capped by the difference between the strike prices, less associated costs.
- The inverse of the above strategy is a Bear Put Strategy (used when an investor believes a stock is headed lower), in which case the investor uses put options instead of call options.
- A Butterfly Spread strategy is designed for when an investor is uncertain of the near-term direction of the market. In this case, an investor would buy an equal number of in-the-money call options and out-of-the-money call options, while concurrently selling at-the-money calls.
In fact, there are dozens of additional spread option strategies, including protective collars (provides downside protection for highly appreciated holdings), long straddles (simultaneous purchase of put and call options), its cousin, the long strangle and more complicated strategies like the iron condor and iron butterfly.
The option strategies an investor pursues should be based on whether he or she believes a stock is going higher or lower, if volatility is likely to increase or decrease and if the risk/reward trade-off is acceptable.
While spread options may be typically associated with individual stocks, they can be employed on a variety of financial instruments, such as market indices, bonds, commodities and currencies.
Spread options can be complicated and confusing. Accordingly, investors should seek to educate themselves to how these strategies work, the risks involved and what strategies best achieve their investment objectives. Since the most effective way of learning is often by doing, investors should start with small, more conservative steps before moving onto the more elaborate spread option strategies.
Investors may also benefit from having a professional financial advisor to help them execute on these strategies in order to avoid costly mistakes.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.