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.
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