What are Options Spreads ?

This item was filled under [ Option Strategies ]

Characteristics of Spreads -

  • Limited Risk / Limited Reward strategies.
  • They can be constructed using either PUT or CALL options.
  • They are directional strategy – Bullish or Bearish
  • They consists of 2 options trades – Buying Option at 1 strike and at the same time selling another option at different strike price.

Cost of the trade = Difference of premium that u pay for buying first leg minus the premium u collect for selling other leg.
Maximum Risk = LIMITED. Cost of trade that is calculated above. (Isn’t it less risky then buying naked call where whole of your premium is at risk)
Maximum Reward = LIMITED. Difference of the two strike prices minus the money that u have paid to open this trade i.e. cost of trade. (Naked option buying, theoretically, has Unlimited reward..but in reality there is nothing called Unlimited. There is a limit to which stock can rise during the life of the option. Similarly it can’t go below Zero. That means it has some limit. )
Break-even point - price level of underlying that must be reached for this trade to be profitable for us. Below that price level, we are in loss because we have paid money to market to take this trade.
This level is = strike price of long leg – Cost of trade (for bearish trade) or Strike price of long leg +cost of trade (for bullish trade)
Effect of time decay = Almost Nil.. When Long leg of your strategy is loosing value due to time decay, the Short leg is gaining approximately same advantage of time decay. (Another advantage over Naked call strategy, where time decay hurts u everyday)
Effect of Volatility = Almost Nil ..During volatile time when u pay more to buy an option, but at the same time when u are selling other options, and collecting more money for same volatility.
Effect of price movement of NIFTY - Any move of NIFTY will have +ive impact on one leg of this position whereas other leg will be -ive impacted. This impact will not be same on both legs depending on
at what level NIFTY is compared to our strike price of 3900/ 4000..

(I have attempted to give this explanation in simple terms to that people with limited knowledge of options trading. I do not want to bring complexity of option pricing / Greeks like delta, gamma, vega here. But if u find it interesting then please read about it from any standard source /book/ site etc and discuss your doubt /experience here).

Happy Trading

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