Investors take two types of positions with an options contract: outright and complex. An outright is when you purchase the contract on its own; your position begins and ends with itself. A complex position is built out of multiple trades and assets and, while they are less common than outrights, they are also where some of the most sophisticated investing happens.
Almost all complex positions start with a spread.
A recent article noted of spread trading that it is “one of the many ways that option traders secure their position… [offsetting] the risks of taking an option position by selling off another one.” This is true, but there are a lot of different ways you can do that.
One of the fundamental categories for understanding spreads is direction. There are three: horizontal, vertical and diagonal. Here’s what each one means.
In a horizontal spread, also known as “time” or “calendar” spreads, you purchase one contract and sell another, changing only the expiration date. The strike price, underlying asset, and option type all remain the same.
For example, to open a horizontal spread for GameCo, you might sell a call contract at a $10 strike that expires on July 1. Then you might buy a call contract for GameCo at a $10 strike that expires on August 1. This would be a call horizontal spread, and could apply equally well to put contracts.
A horizontal spread profits off of time decay, otherwise known as implied volatility. In any spread, the contract that expires soonest will have more volatility and a higher premium associated with it. The long term leg will have less volatility and corresponding premiums. Managing that depends entirely on your outlook on the underlying asset.
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Vertical spreads are arguably the “classic” spread.
In a vertical spread, you purchase one contract and sell another, changing only the strike price. The expiration date, underlying asset, and option type all remain the same.
For example, you can open a vertical spread for GameCo by buying a call contract for a $10 strike that expires on July 1. Then, to hedge your bets, you will also sell a call contract on the same stock for $12.
What happens? If the stock plunges below $10, both contracts expire worthless but you have recouped some money with the premiums from the option you sold. If the stock rises, but settles below $12 per share, then you collect the profits of your contract and keep your premium. If the stock rises above $12 per share, you collect the profits of your contract to a maximum of $12 because you have to pay out on the other contract, then keep that and the premium.
There are many ways to structure a vertical option, but virtually all are built to minimize losses on one contract at the expense of capping gains.
Diagonal spreads are more complex.
In a diagonal spread, you purchase one contract and sell another, changing both the strike price and the expiration date. The underlying asset and the option type both remain the same.
In one sense, the diagonal spread is simple. You are simply selling an entirely different contract, albeit on the same underlying asset and terms.
In another sense, this is a highly complex trade. By moving the expiration dates, a diagonal spread profits from differences in time decay; longer positions experience more volatility than shorter ones. At the same time, these contracts can also help create a more secure position because of the offsetting risks inherent to using different strike prices.
The result is a complicated position, and one which deserves further exploration in another article.
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