An optiosn spread is among the most popular options trading strategies. It involves buying and selling multiple options contracts of the same type and having the same underlying security. Whereas, the same type means you either buy and sell multiple put options or call options. Moreover, the strike price and the expiration date are generally different.
Options spread strategy is very useful if executed accurately. If you want to know all about this strategy, then you are on the right platform. In this article, we are going to explain different options spread strategies. Therefore, you will be able to decide which will get you the best returns by the end of this article. So, don’t go anywhere else and continue reading.
Options spread options trading strategies
As you know, options spread strategies involve buying and selling multiple call options or put options. They have the same underlying security but different strike price and expiration date. So, that is the simple strategy but the question is “why do traders use this strategy?” Let’s see.
Why do traders employ this strategy?
Options trading has become quite popular among traders and investors. Have you ever thought about “why?” Why has options trading attracted so much interest and attention? The answer is risk and loss potential. Options contracts limit risk and loss potential. Let me explain. The loss potential is very minimal if the market goes against you. You will lose only the premium paid which is a very negligible loss as compared to losing money on shares. Conversely, if the market moves in your favorable direction, the profit potential is significantly high.
However, the biggest problem in this option play is the timeframe. What if the market takes too much time to move in your favorable direction? What will you do? Yes, you will employ options spread strategies. These strategies offer higher potential profit and aren’t much affected by other factors like the time period.
Three types of options spread strategies
First things first. Before moving to types of options spread, follow the following tips when employing this strategy.
- Buy the options contracts with a strike price closer to the current market price of the underlying security of your choice.
- Whereas, selling the options contracts with underlying security faces fewer price variations.
- Choose call options with a strike price greater than the current market price. Contrarily, choose put options with a strike price lower than the current market price.
Now, let’s get back to the three types of options spread strategies.
1. A vertical spread strategy
A vertical spread strategy, also known as a money spread, involves using two options with different strike prices but the same expiration date. Traders using this strategy seek to limit their downside risk. However, they also cap their potential profit. That means looking for safety also minimizes potential profit.
2. A horizontal spread strategy
A horizontal spread strategy, also known as a calendar spread, also involves using two options contracts. One is a long options contract while the second is short and with the same strike price but a different expiration date. Traders using this strategy seek benefits from the theta factor or time decay factor. The theta explains the upcoming price variation in the price of the underlying security with the passage of time.
Now, the purpose of using both short-term and long-term options contracts is to offset losses incurred in the short-term with the long-term options.
3. A diagonal spread strategy
A diagonal spread strategy involves entering into both long and short positions simultaneously. The options used in this strategy are the same but with different strike prices and different expiry. Traders using this strategy seek benefits from both theta and delta (the price fluctuations of the underlying security at every step).