Option Spreads - A Strategy to Reduce Your Margin and Risk

Option Spreads - Overview

Introduction

When we talk about options we used to discuss about the option premium either paying or receiving. When you are buying an option you have to just pay the premium. When you are selling an option, you have to pay the span and exposure margin associated with it. However, if you are buying and selling multiple options (with the same underlying) then concept of option spreads kicks off.

What is an Option Spread?

Option spreads are derived by combining multiple option position in the same underlying to produce specific payoffs. The bull call spread strategy is an example of option spreads at work. The strategy is where you partially offset the price of buying at the money call option against the writing of out the money call option of the same underlying at the same expiration. Whenever we have more than one option of this kind (same underlying, same expiration), we are creating an option spread.

Types of option spreads

Option spreads classifieds by the relative positions involved in the spread as well as the capital structure of the option position.

The main categories of option spread are:

1. Vertical Spread

   A very good example of vertical spread is the bull call spread. This involves buying an at the money call option and selling an out of the money call option of the same expiry with different strikes. This helps in reducing the capital required while entering the trade.

2. Horizontal Spread

   Used to hedge against short term price fluctuation. A classic example of the horizontal spread is buying the current month option and selling the same option expiring the next month (strike price remains the same).  This is also known as the calendar spread.

3. Diagonal Spread

   A combination of vertical and horizontal spreads using different strike prices and expiry dates). For example: - buying a call of current month and selling the same call with a slightly higher strike expiring in the next month.

4. Debit and Credit Spreads

   A debit spread would be an option spread wherein you pay money. A credit spread would be an option spread where you receive money out of the positions you entered. A bull call spread is an example of a debit spread where you buy in/at the money and sell out of the money. The sell trade offsets the cost of the buy trade. The bull put spread is an example of a credit spread where you sell in/at the money put options to offset the cost of buy out of the money put options.

Conclusion

Once you are acquainted with option spreads and how they work, the next step is to use them in your day trading. This will help you understand options in detail and the mechanics of option spreads. If you are an option seller, this can be very beneficial because spreads have the greatest potential for you to profit from both time value and decay.