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Tuesday, March 1, 2011

What is an options spread?

An options spread is a technique used in stock options trading that makes use of two financial instruments known as 'options' orders so as to hedge risk and increase probability of profit by making use of different price movements by writing, selling, and/or buying options. An options spread can be used with any underlying market that allows trading via options.

The name option spread is no coincidence as the option is literally an option to use a financial instrument for a price. A spread represents two price points such as in a bid/ask spread, only in options, the spread is between two prices. When the words 'option' and 'spread' are brought together, so are the meanings of each word i.e. two options that represent a trading technique that involves financial contracts.

How an option spread works

Options are a derivative financial instrument meaning their value is derived from an underlying product. For example, with stock options, shares of a company are packaged into groups of 100 and bought and sold for a contract price or premium. The options can be either in the money, at the money or out of the money. This means the price of the underlying financial instrument can be either profitable, not profitable or even when exercised or used.

This contract, if bought, allows buyer to 'exercise' the options at a certain price before a specific date. If sold, the buyer of the option pays a premium to the seller and the seller pays the buyer if the option is exercised 'in the money' or beyond the 'strike' price i.e. the price after which the option becomes profitable. Some of the key elements of an options spread are listed below:

• Order type: ex: Limit order, market order, stop loss
• Risk: Potential to lose money via the spread
• Market: ex. Bull, bear, secular, cyclical
• Strategy: Option spread(s) used
• Broker: Trade facilitator
• Product: Stocks, commodities, currency

Types of option spreads

The type of option spread used reflects the strategy of the spread. For example, a calendar spread makes use of two different expiration dates for the same type of option. This type of spread may be used when the buyer or seller is convinced of a price movement but not the time when the price movement will occur. A number of different spread types exist, some of which are listed below:

• Bull Call Spread: Hedges cost of bullish options
• Bull Put Spread: Premium benefit if stock remains above strike price
• Bear Call Spread: Benefits flat price movement
• Bear Put Spread: Inverse of Bull Call Spread
• Calendar Spread: Makes use of different option expirations
• Backspread: Lowers risk for up and down price movements

Each of the above mentioned spreads makes use of different option types, techniques and predicted price movements. The variable element is the price movement which is it not guaranteed, and the details of each spread involve several variables and concepts, only a few of which are mentioned herein. In other words, when researching and making use of option spreads, it can be a good idea to pay close attention to 1) how the spread works, 2) when it is profitable, 3) the likelihood of it succeeding and 4) the monetary risk involved.

An options spread is trading mechanism that makes use of two financial instruments known as options. These are comprised of products from which the options' price is derived. Different types of options spreads are used to make use of 1) different price movement directions, 2) time of price movement, 3) extent of price movement and 4) combination of options used.

Options spreads are bought and sold using brokers and trade through markets such as the Chicago Board Options Exchange (CBOE). Options spreads are regulated by the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC). These regulatory bodies are further assisted by the participation of individual options exchanges in collaborative surveillance of their business through the Options Regulatory Surveillance Authority (ORSA)

Source: http://www.optionseducation.org/ (Options Industry Council)