Chapter 6 will introduce students to vertical option spreads. Spreads are different from directional call and puts in that they have defined profit potential but lessen the initial cost outlays to open the position.Spreads can also be designed to have a higher probability of success and/or take advantage of time decay.
First off, there are two types of vertical spreads:
Debit Spread
A type of spread in which an investor simultaneously buys a call or put option and writes a further OTM option with the same expiration date. The position creates a net debit because the purchased option has a higher premium than the written option.
Credit Spread
A type of spread in which an investor simultaneously writers a call or put option and buys a further OTM option with the same expiration date. The position creates a net credit because the written option has a higher premium than the purchased option.
Using vertical spreads, here are two examples of how an investor can open a bullish position on an underlying stock. The debit spread reduces initial outlay cost to open a position and the credit spread has a high probability of success even if the underlying stock is neutral in price between now and expiration.
Debit
Spread (Bull Call Spread)- An investor is bullish on Mastercard
which
is trading at $230 per share. The investor purchases the December 240
call option for a debit of $6.00 and writes the December 250 call
option for a credit of $2.40. The cost to open the trade is reduced
from $6.00 to $3.60 now because of the added written option. $3.60 also
represents the maximum risk on the trade.
The disadvantage to the debit
spread is that reward is no longer unlimited. The maximum reward at
expiration would be $6.40, no matter how high the underlying stock may
go. The advantage to debit spreads is that they reduce overall cost to
open a position as well as risk.
Credit
Spread (Bull Put Spread) - Another investor is also bullish on
Mastercard which is trading at $230 per share. However, this investor is
not as bullish as the previous investor. Therefore, the
investor doesn't want to worry how much higher Mastercard shares are
trading at expiration- just that they will be trading higher. To
accomplish this, the investor writes the December 220 put option for a
credit of $3.00 and
purchases the December 210 put option for a debit of $1.50. By
purchasing the further OTM put option, the investor limits downside
risk.
Because the written option is worth more than the purchased option,
there is a credit of $1.50 left
over. As long as Mastercard shares are trading above $218.50 at
expiration, the investor keeps the $1.50 premium and both options
expire worthless. The trade off to a credit spread is that the broker
will require margin.
Furthermore, both types of spreads can be broken down into bullish and bearish positions:
Bullish Spreads
Bull Put Spread (credit)
Bull Call Spread (debit)
Bearish Spreads
Bear Put Spread (debit)
Bear Call Spread (credit)
The following lessons will introduce each type of spread and how an investor can utilize them.
| < Prev | Next > |
|---|