We’ve covered some of the basic options strategies out there before. In the past, we’ve focused on how traders can do things like buy calls, sell covered calls, buy puts, or sell puts.

We’ve also covered why some of the basic assumptions investors make about options (that they’re risky or complicated, for example) are not always correct. We’ve even delved into some intricacies of these strategies and how traders can maximize their chances for success.

The truth is, there are many options strategies out there. Some are riskier (or more complicated) than others. So today, let’s move beyond the basics and discuss an options strategy that’s a little more complex (but not too complicated).

It essentially involves taking two option positions on the same stock. This is known as a “spread” trade and can offer tremendous benefits depending on how it’s implemented.

How Spread Trades Work

We’ve discussed the process of writing a covered call before. As you may remember, this involves selling an option on a stock you currently hold in your portfolio. A spread is very similar to a covered call, except it basically involves covering an option instead of the underlying stock. An investor might utilize this strategy if they feel that a stock will move in one direction but believes the gains will be limited.

To execute a spread trade, the investor must buy an option at one strike price, then sell an option at a strike price farther out of the money. Both contracts should expire in the same month.

Since this type of trade involves the sale of an option, the trader will receive initial income from this transaction. The income received will not be enough to offset the cost of buying the first option, but it will lower the overall cost of the trade. However, in exchange for this lower transaction cost, the investor will essentially forfeit any gains they would have earned above a certain set level.

To gain a better understanding of how a spread trade works, let’s take a look at an example…

Let’s suppose shares of XYZ are trading at $100, and you have no current position in the stock. By the time of option expiration, you feel that XYZ will likely trade above $105 but will not climb higher than $110.

Let’s assume that the price of an XYZ 105 call option is $3. Meanwhile, the XYZ 110 calls are selling for $1. To maximize the profit potential from this scenario, you might decide to purchase a spread. To do this, you would buy the XYZ 105 call for $3, and at the same time, sell the XYZ 110 call for $1. The net result of these two transactions would be a debit of $2 ($3 paid to purchase one option – $1 received for the sale of the other option).

This strategy lowers the amount you have at risk in the trade to $2. But it also limits your upside potential to $3. You can see how this works in the diagram below. In this particular example, the market is not predicting a great deal of volatility in XYZ, as reflected by the low option costs.

Closing Thoughts

There are a variety of different ways to use spreads when trading. This is just one example. (Stay tuned, and we will cover more in future articles.)

Another commonly used spread, for example, is called a calendar spread. In this type of spread, an investor believes that a particular stock will move to a certain price but will not do so during the period of time defined within the trade parameters.

To execute a calendar spread, you would buy an option (usually out-of-the-money) with an expiration date later in the year and simultaneously sell an option set to expire closer to the present time. The desired result is for the option sold with the closer expiration date to expire worthless, yet for the stock to come close to its strike price. You would then keep the option premium earned on this sale and use the proceeds to offset the cost of purchasing the other option.

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