Skip to main content

Beacon Equity Research

Introduction to Options

Table of Contents

Spreads/Combinations

A virtually limitless number of options trading strategies are available to investors. In today's installment of our series on options trading my staff and I will discuss two more advanced strategies--the spread trade and the combination trade. Both of these trades involve taking two option positions on the same stock.

Spread Tables

In a previous options lesson we discussed the process of writing a covered call. As you may remember, this involves selling an option on a stock that you currently hold in your portfolio. A spread is very similar to a covered call, except it basically involves covering an option instead of the underlying stock. An investor should utilize this particular strategy if he/she feels that a stock will move in one direction but believes the gains will be limited.

To execute a spread trade, the investor must buy an option at one strike price, then sell an option at a strike price that is farther out-of-the-money (both contracts should expire in the same month). Since this type of trade involves the sale of an option, the trader will receive initial income from this transaction. The income received will not be enough to offset the cost of buying the first option, but it will lower the overall cost of the trade. However, in exchange for this lower transaction cost, the investor will essentially forfeit any gains that he/she would have earned above a certain set level.

To gain a better understanding of how a spread trade works, let's take a look at an example...

Let's suppose shares of IBM are trading at $100 and the trader in our example has no current position in the stock. By the time of option expiration the trader feels that IBM will likely trade above $105, but will not climb higher than $110. Let's assume that the price of an IBM 105 call option is $3. Meanwhile, the IBM 110 calls are selling for $1. To maximize the profit potential from this type of scenario, the investor would probably decide to purchase a spread. To do this, he or she would buy the IBM 105 call for $3 and at the same time sell the IBM 110 call for $1. The net result of these two transactions would be a debit to the trader of $2 ($3 paid to purchase one option - $1 received for the sale of the other option).

As shown in the diagram below, this strategy lowers the amount that the trader has at risk in the trade ($2 in this example), but it also limits his/her upside potential (to $3 in this case). In this particular example the market is not predicting a great deal of volatility in IBM, as reflected by the low option costs.

There are a variety of different ways to use spreads when trading. Another commonly used spread is called a calendar spread. In this type of spread, an investor believes that a particular stock will move to a certain price, but will not do so during the current period of time. With this in mind, to execute a calendar spread the investor would buy an option (usually out-of-the-money) with an expiration date later in the year and would simultaneously sell an option that is set to expire closer to the present time. The desired result is for the option sold with the closer expiration date to expire worthless, yet for the stock to come close to its strike price. The investor would then keep the option premium earned on this sale and would use the proceeds to offset the cost of purchasing the other option.

Combination Trades

A combination is an option strategy where the trader takes a position in both call and put options in the same underlying stock. For the sake of example, in this section we will look at a very popular trade called a long straddle. In this particular type of trade, an investor will purchase both a call and put on the same stock, and both of these options will have identical strike prices and expiration dates.

It may initially sound counterintuitive to be on both the long and short side of the same stock. After all, if you're only trading regular common stocks, it doesn't make sense to be both long and short at the same time. In the wonderful world of options, however, it is sometimes beneficial to enter into this type of trade. Straddles are designed to allow investors to profit from a large move in a given stock. The beautiful thing about them is that the actual direction the stock takes does not matter, the only thing that matters is whether the stock makes a substantial move. This is the key point to trading straddles. An investor does not have to be certain which direction the stock will move; just certain it will move strongly one way or the other. Because of this, straddles make an excellent choice in choppy markets where the only certainty is high volatility.

Let's take a look at an example of how a straddle trade works...

Once again, let's assume that IBM is currently trading at $100 per share. Due to a significant event that will occur this month (an expected news event, earnings release, etc.), an investor might believe that the stock will move at least 10% in either direction. In this example, let's assume that both the IBM 100 put options and IBM 100 call options are trading at $3 each. To take advantage of this the investor would enter into a straddle trade by purchasing both the IBM 100 put for $3 and the IBM 100 call for $3 (for a total of $6 out of pocket).

As you can clearly see in the payoff diagram of this trade above, this particular straddle will be profitable if the price of the stock moves more than $6 in either direction by the time the options expire. If the price remains at exactly $100, then the investor will suffer a maximum loss of $6. Once the price of IBM's underlying shares moves beyond $94 or $106 the investor will begin to realize a profit from the trade. If the price does indeed move at least 10%, as the investor predicted, to either $90 or $110, then the profit will be $4 ($10 sale of option - $3 purchase of call - $3 purchase of put).

Both spreads and straddles are designed to limit an investor's losses yet still allow him/her to realize significant gains. By using multiple option positions at the same time, you can create powerful tools to help you earn greater returns as well as manage risk in your portfolio. With some planning and a little practice you can use the same techniques that professional traders employ to earn above-average profits.