The Ins and Outs of Spreads
Hey folks, Phoenix here!
With Nate traveling abroad I figured I would take a moment today to teach another lesson about options trading.
So today I want to talk about spreads, one of the most important vehicles we can use as options traders.
There are two basic types of spreads, debit spreads and credit spreads.
Debit Spreads:
This strategy involves simultaneously buying and selling options of the same type (calls or puts) on the same underlying asset with different strike prices or expiration dates. You pay to enter the trade, hence the term “debit” spread.
The goal is for your long position, which is the option you bought, to increase in value more than your short position (the option you sold), maximizing your gains as the market moves in your desired direction.
Credit Spreads:
Credit spreads are a little different. You sell a more expensive option than you buy, thus you receive money upfront with credit spreads — a “credit”.
This strategy also involves simultaneously buying and selling options but is structured so that the premium received for the option sold is greater than the premium paid for the option bought.
The ideal scenario for credit spreads is for the options to expire worthless, which means you pocket the initial credit as pure profit.
When trading credit spreads, the maximum profit you can hypothetically receive is the credit you receive when entering the trade.
Here are a few examples of how these work in the real world:
Imagine you’re bullish on XYZ stock, and it’s currently trading at $50.
You could set up a “bull call spread” by buying a call option with a strike price of $50 and selling a call option with a strike price of $55.
This spread limits your maximum loss to the cost of the spread, which is the price you pay for buying the $50 call, minus the premium you collect for selling the $55 call.
On the flip side, your potential profit is capped at the difference between the strike prices ($5 in this case) minus the cost of the spread.
You would use a “bear put spread” if you think the price of the stock is going to go down. So you could buy a put with a strike price of $50 and sell a put with a strike price of $45.
This strategy also limits potential losses to the net cost of the spread and provides profit potential down to the lower strike price.
And one of my favorites is what’s known as a “bull put spread”. It’s a tactic you can use when you think the price of a stock will go up.
To perform a bull put spread you would sell a put option at a higher strike price ($50) and buy a put option at a lower strike price ($45).
Because you are selling a more expensive option than you are buying you receive a net credit.
Your maximum profit is the credit received, and you fully achieve this if XYZ stays above $50 at expiration. The maximum risk is the difference between the strike prices minus the credit received.
As Nate wrote to you on Monday, he discussed diversifying your strategies — not just your investments — and spreads are a great way to diversify your trading strategies and make some serious money while doing so.
I highly recommend all investors learn more about these diversified strategies and especially take some time to learn about spreads.
Or if you’d like someone to walk you through how spreads work with live classes, free trading events, and curated picks, you can check out Nate’s Automated Options system right here.
His students have won the program’s first 9 trades in a row, with each logging a gain of around 50%.
Let’s build wealth together!
— Phoenix van Zutphen
