Visually construct and analyze options strategies

Basic Spreads

Introduction

When an investor is looking at XYZ and its exchange-listed options, he or she is looking at 3 distinct investment products:

  • XYZ stock,
  • XYZ's Calls, and
  • XYZ's Puts.

While they each have their own unique risk/reward characteristics, they are all, most assuredly, interrelated.

The flexibility of options: Each trading day, thousands of investors, each with their own outlook financial situation and tolerance for risk, converge upon the options markets.

By using an option either by itself, in combination with other options, or with the underlying stock itself, an investor can create a position that reflects his or her expectations and, at the same time, balances his or her tolerance for risk.

The flexibility of options

They can be used in many combinations with other option contracts and/or the underlying stock to create either a hedged or speculative position.

Options are an extremely versatile investment tool.

They may be used within an investment portfolio because of their decay potential, protection ability, substitutability for a stock position, or simply leverage.

Building Blocks

  • Long Stock. Short Stock.
  • Long Call. Short Call.
  • Long Put. Short Put.

By examining each block individually, the investor can build a solid foundation.

Using the blocks to build spreads: Limited vs. unlimited risk? Unlimited vs. limited reward? Each of the six building blocks has its own unique risk/reward profile.

Now, what if an investor were to combine these individual blocks? Would the resulting positions have their own unique risk/reward profile?

The answer, of course, is yes! And, the resulting position is known as a spread.

Spreads

A spread is a position consisting of at least two pieces, each of which alone, would profit from opposite directional price moves in XYZ.

The pieces are executed at the same time in the hope of:

  • limiting the position's risk, or
  • benefiting from a change in the price relationship between the two due generally to either time decay or a change in volatility.

Basic Spreads

By combining options and/or stock into spreads, the investor can add even more flexibility to his or her investment planning.

Most complex option spreads have as their foundation one of two basic spreads. They both involve buying one option and writing another.

The two basic spreads are:

  • Time Spreads: A time spread is an Options Strategy which involves options with the same strike price, but different expiration months.
  • Vertical Spreads: A vertical spread is an Options Strategy which involves options within the same expiration month, but with different strike prices.

These profiles (time spread & vertical spread) are the foundation for almost every other type of spread the investor will encounter.

They illustrate the impact of changes in time, stock price, and volatility - on not just one option, but on the combination of two options.

The two basic spreads are directional by design. This means that the investor can use the same basic spreads with various market opinions for XYZ.

Options Strategies :: Basic Spreads Back to top