Spread Option

As we’ve mentioned earlier, a spread option can be used in a variety of ways, and some of these forms of spreads are advanced strategies that involve a more complex analysis. But don’t think that just because an option strategy is more advanced and difficult, it has better odds than a more simple strategy. On the contrary, a simple strategy could be just as effective. Besides, more advanced strategies may involve more risk, thus better left to the more experienced trader.

 

Before we go on with examples of how to use a spread option, let’s explain the two basic categories of spreads: bull spread and bear spread.

 

 Bull Spread: buying and selling a call option, or buying and selling a put option, where your profits increase as the value of the underlying commodity rises. In a bull strategy, you buy an option with a lower striking price, and sell an option with a higher striking price.

Bear Spread: buying and selling a call option, or buying and selling a put option, where your profits increase as the value of the underlying commodity drops. In a bear strategy, you buy an option with a higher striking price, and sell an option with a lower striking price.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

So there are really four possible forms of spread:
bull spread using calls
bull spread using puts 
bear spread using calls
bear spread using puts

 

Examples:

BULL SPREAD

You’re following corn prices through the newspapers. It’s now the month of June, and corn is currently trading at $2.75 a bushel. There’s a seasonal tendency for corn prices to rise into July and August, and it generally bottoms around November. Expecting that this tendency will continue, you decide to implement a bull spread strategy. So you buy an August $3.00 call option on corn, paying a premium of 4.5 cents, which translates into $225 ( .045 x 5,000 bushels = $225) (For simplicity we won’t calculate commissions and transaction costs).

Your option is 25 cents out of the money. Plus the 4.5 cents for the cost of the premium puts your break-even point at $3.04 1/2. So you know that as long as the price of corn rises beyond this point before its actual July expiration date, you’ll make money. But if it doesn’t, you lose your premium. So, to limit your loss against this possibility, you sell 2 August $3.30 call options on corn. The premium you receive for these call options is 2.25 cents each. In other words, a total of $225 (.0225 x 5,000 bushels = $112.50. Multiply 112.50 x 2 options = $225.)

What you’re really doing here is buying one out of the money call, and selling 2 further out of the money calls. At this point, this trade isn’t costing us a penny (once again, commissions and transaction costs calculations are left out for simplicity).

So let’s look at the possibilities with different scenarios:

  1. The price of corn doesn’t move (or declines), so therefore we haven’t made nor lost anything. In fact, this situation will hold true all the way up to the break-even price of $3.04 1/2.
    Outcome = We broke even (however, we’d be out on our brokerage fees.)

     
  2. The price of corn goes up to $3.20 by the end of June. We decide to exit our position early with offsetting transactions. That is, we buy back the options we sold and sell back the option we bought. By selling back the option we bought we’ll make $1,000 (.20 x 5,000 bushels = $1,000), minus our cost of $225, equals a net profit of $750. To this amount, we should add the money we collected on the premiums for the options we sold. However, since we’re buying back the options we sold a little early, we’re giving up part of the premiums. Suppose that to buy back the options we pay a premium of 1.25 cents each (remember, at this point the option has lost time value.) That’s a total of $125 (.0125 x 5,000 bushels = $62.50, multiplied by 2 options = $125). Since we had received $225 when we sold the options, we’re still ahead by $100.
    Outcome = Total net profit from this bull spread strategy = $850.

     
  3. The price of corn goes up to $3.30 by expiration time. Therefore, before expiration we sell back the call option we bought for a profit of $1,500 (.30 x 5,000 bushels = $1,500), minus our premium of $225, equals a net profit of $1,275. PLUS, the two call options we sold expire worthless for the buyer, so we keep the $225 premium money we had collected.
    Outcome = Total net profit = $1,500.

     
  4. The price of corn reaches $3.60 by expiration date. Now, on the option you bought, you’ll make $3,000 (.60 x 5,000 bushels = $3,000) minus the $225 premium you paid = $2,775 net profit. On the options you sold, you’ll lose $3,000 (.30 x 5,000 bushels = $1,500, multiplied by two options = $3,000), minus the $225 premium you collected = $2,775 loss.
    Outcome = We broke even.

 

As you can see, after the $3.30 level it was dollar for dollar. That is, we lost a dollar for every dollar we made. As the price of the commodity rises we make money with the call option we bought, up to the point when we start losing money with the call option (or options) we sold. Thus, our profits are limited (in this case, up to $1,500); but so are our losses!

One side note, we’ve could have sold just 1 call option instead of 2. Thus, we would have only collected one premium for $112.50. Our total exposure for the entire transaction would have been limited also to $112.50. By altering our spread a little and selling two options instead of one, we altered the possible outcomes under each one of our scenarios:

 

               SELLING TWO OPTIONS                                      SELLING ONE OPTION

 

    1                    Broke even                                                       Net Loss = $112.50

 

    2.               Net Gain = $850                                                   Net Gain = $800

 

    3.              Net Gain = $1,500                                              Net Gain = $1,387.50

 

    4.                 Broke even                                                     Net Gain = $1,387.50

Of course, we could have entered this bull spread using puts instead. Our thinking would have been that the price of corn was going to be declining over the next few months.

So back to our corn example, the price in June when we entered the trade was $2.75 a bushel. If we wanted to use puts, we would buy an August $2.50 put option, and sell 2 August $2.20 put options. That is, we’re buying an out of the money put, and selling 2 further out of the money puts. The math is exactly the same, only we’re going in the opposite direction.

Naturally, there are variations on any bull spread. As we mentioned earlier, we could have just bought one out of the money call and sold one further out of the money call. Or, we could sell an in the money put and buy an out of the money put. In this case, we’d collect a higher premium for the put option we sell, because it’s in the money already. If the price of the commodity rises, your short position will lose its premium value at a faster rate than your long put, so you would then make profits from your long position.

 

BEAR SPREAD

Let’s say you’re looking at soybeans. It’s the month of September, and soybeans are trading at $7.00 a bushel. The seasonal tendency is for beans to decline in price in the autumn and rise in price in the spring. You believe this tendency will hold true this year, especially since you’ve read that this year the carryover percentage is 40%, which is quite high. So you decide to implement a bear spread strategy. You sell a November $8.00 call option for soybeans, and receive a premium of 15 cents, that is, $750 (.15 x 5,000 bushels = $750.) At this point, $750 is considered unrealized gain, and your risk is technically unlimited.

You’re expecting the price of beans to fall. Since this call option will actually expire at the end of October, your total time risk is only about two months. But just in case you’re wrong about the price of beans falling, you want to protect your downside. So you apply a bear spread and buy a $8.25 November call option for 7 cents. That is, $350 (.07 x 5,000 bushels = $350.) At this point, you’re making $400 in profits.

Let’s review the possibilities:

  1. The price of soybeans declines, remains the same, or increases, but not beyond the strike price of $8.00. Thus, you make $750 from the call option you sold, and lose $350 from the call option you bought.
    Outcome: Your net profit = $400.

     
  2. The price of soybeans goes up to $8.25. You lose $1,250 (.25 x 5,000 bushels = $1,250) minus the $750 premium = $500, plus the $350 from the option you bought = $850. This is your maximum possible net loss, and hence, your worst case scenario. Remember, as the price of soybeans rises, you could close your position any time before expiration and avoid letting your short position gain value. But if the price jumps too quickly, you might not have time to do this. In this case, it reached $8.25 and the buyer exercised his option.
     
  3. The price of soybeans goes beyond $8.25, up to $9.00. Now the money you’re making from the call option you bought is $3,750 (.75 x 5,000 bushels = $3,750) minus the premium of $350 = $3,400. While from the option you sold, you’ll lose $5,000 ($1.00 x 5,000 bushels = $5,000), minus your $750 premium = $4,250. Outcome: Your net loss is $850.

 

As you can see by this example, if you had just outright sold the soybeans call option your maximum potential gain would have been $750, while your maximum potential losses could have been unlimited. By applying a bear spread, you limited your maximum potential gain to $400, but also limited your maximum potential losses to $850.

Why would you do this? Because, what market analysts have found to be true over the years, is that the odds of the underlying commodity reaching the strike price before expiration is less than 20%. Therefore, there’s over an 80% chance that scenario 1) from our example would repeat itself. So in our example, it comes down to this: would you risk up to $850 at a 20% chance of losing, in order to earn $400 at an 80% chance of winning?  There’s really no right answer. This is a personal decision. In a way, it’s like being in the insurance business. You collect money from the insurance policies, but there’s a 1 in 5 chance of having to pay a large claim.

And of course, we could have entered this bear spread strategy by using puts. Again, there’s no difference in the math, we’re just betting in the other direction.

 

VERTICAL SPREADS

When you’re trading options that have different striking prices, but dentical expiration dates, you’re involved in a vertical spread (also known as a ‘money spread’).

This is what we’ve just been doing in our previous examples. In other words, a vertical spread can be a vertical bull spread or a vertical bear spread. You can use vertical spreads to take advantage of price changes in the premium value. Generally speaking, when an option is in the money, its price will probably change much faster than when it’s out of the money. On this assumption, you open offsetting long and short positions just as we’ve done with our previous corn and soybeans examples. You expect your position that is in the money (whether it’s the long or short one) to increase or decrease in price faster than the offsetting option.

 

CREDIT SPREADS

A spread position can be entered not only to limit risks, but also to generate profits. A credit spread is a spread that generates a positive cash flow. That is, one in which more cash is received through premiums collected on short positions than paid out on premiums for long positions (The reverse is called a ‘debit spread’. That is, when more cash is going out than coming in through premiums).

We saw this in our beans example. We received $750 on our short position, and paid out $350 for our long position, a classic credit spread. On the other hand, with the corn, we paid out $225 for our long position, while only receiving $112.50 per premium on our short positions, which would qualify it as a debit spread. 

In a credit spread, you’re basically using a portion of the premium you’ve collected to cap your risk. Going back to our insurance company analogy, insurance companies use a service called reinsurance to control risk. That is, they take a portion of the premium money they collect from their policies, and then turn around and purchase insurance of their own.

This puts a dent in their profits, but it also limits their exposure in case of a large claim. Their losses won’t be devastating.
 

Go to Straddle Option to continue.