Hey Trader,

If you’re someone that is trading just straight calls and puts …

There’s a whole wide world of trading you’re missing out on!

And it could be keeping you from making a lot of money.

These are trades that are intimidating to some traders …

But they really shouldn’t be.

Because once you get them down, you’ll realize … they’re really no harder than the trades you’re already making!

In fact, in many ways they’re easier …

I’m talking about spread trades.

Spread trades involve opening multiple “legs” of a trade at once. By having multiple trades on, you’re able to do things like lower your risk, reduce the cost of the trade, and even target specific options pricing factors to profit!

But a lot of traders think spreads are “too hard” or “too advanced.”

I’ve got news for you … they’re not! Your broker just wants you to THINK they are.

Why?

I’ll let you in on a little industry secret …

Your broker doesn’t really want you making spread trades. 

They want you trading simple calls and puts, because it’s easy money for them.

Spread trades often give you better pricing … which means less profiting from the bid/ask spread for your broker.

But we’re not here to look out for your broker’s profit margins now, are we?

So let’s take a look at some basic spreads … (and next week we can get into some that are even MORE fun!)

Call Spreads

If you’ve traded spreads … a simple call or put spread is likely what you started with.

Call spreads and put spreads are fairly straightforward …

Buy one call (or put), and sell another call (or put).

These are either bullish or bearish. We’ll briefly go over each.

In a bull call spread – also called a long call spread, or a call debit spread – you’re buying one near-the-money or out-of-the-money (OTM) call, and selling a further OTM call.

Here’s a recent Big Money bull call spread …

The sale of the further OTM call helps finance the nearer-to-the-money calls. However, it also caps your gains.

Let’s look at an example.

Say stock XYZ is currently trading at $50. You think it will reach $55, but won’t go as high as $65.

So you buy a 55-strike call for $1, and sell a 65-strike call for $0.50. This brings the net cost of your trade from $1 (or $100) to just $0.50 (or $50).

So if XYZ doesn’t reach the lower strike of $55, you only lose half of what you would have lost if you had just purchased the call outright.

It also moves your break even point from $56 to just $55.50, so your option becomes profitable sooner.

However, let’s say XYZ rallies hard, and shoots up to $70. Your profits are capped at $9.50 (the $10 difference between strikes, minus the $0.50 premium spent), so you miss out on an extra $4.50 of profit (remember, your trade price would have been $1 had you simply bought the call outright).

So you’re trading off some potential profits for a lower cost of entry, and therefore lower risk.

A bear call spread (also called a call credit spread, or a short call spread) is constructed in the opposite direction. You would sell a near-the-money call, and buy a further OTM call.

So using the example above, if you think stock XYZ will actually move lower, you would sell the 55-strike call for $1, and buy the 65-strike call for $0.50. 

This nets you a $0.50 credit, which you will get to keep if XYZ remains below the 55-strike of the sold call. This is also your maximum profit.

And if XYZ rallies, and heads to $70?

Your maximum loss is limited to the difference between strikes, minus the premium received – so in this case, your maximum loss would be $9.50 – which is $4.50 less than if you had simply sold the 55-strike call outright.

Put Spreads

Like call spreads, put spreads can be bullish or bearish.

By putting on a spread, you’re able to limit your capital at risk, though at the cost of also limiting your potential profits.

A bull put spread (also called a put credit spread, or a short put spread) involves selling a near-the-money put, and buying a further OTM put. Since near-the-money put will have a higher price, this results in net credit to the trader (hence put CREDIT spread). This credit is the maximum profit, while the maximum loss is the difference between strikes, minus the premium received.

So, once again, let’s go through a quick example.

Let’s say XYZ is trading at $50, and you do not expect it to fall (or at least fall much).

You might sell a 45-strike put for $1, while buying a 35-strike put for $0.50.

This nets you a $0.50 credit, and should XYZ fall below $35, your maximum loss is $9.50.

Now let’s say you think XYZ is headed for trouble, and will fall in short order.

In this case, you would construct a bear put spread (also called a put debit spread, or long put spread).

This involves the purchase of a near-the-money put, paired with a sale of further OTM puts.

Here’s a real-world Big Money example to illustrate…

This results in a net debit to your account, which is your maximum risk should the trade turn against you.

Using the same XYZ example above, if you expect XYZ will fall below $45, but not below $35, you would purchase the 45-strike puts for $1, while selling the 35-strike puts for $0.50.

This again lowers your capital at risk, and also lowers your breakeven price from $34 to $34.50.

And should XYZ fall to $35 or below, your maximum profits will be capped at $9.50.

Generally, if you are receiving a credit for opening a spread (such as in a bear call spread or a bull put spread), you are looking for something NOT to happen (you do not want the equity to move above or below the strike of the sold option).

Meanwhile, when you are paying a debit to open a spread, you are usually looking for something to happen; you want the underlying to move in the direction of your long option, without going above or below the strike price of your sold option.

Seems simple enough, right?

Once you understand these, the whole wide world of spreads will open up to you.

Yes, it gets more “complex” in terms of how many options you have, or in terms of how you are targeting your profits and limiting your risk, but in essence, spreads simply allow you to fine-tune the risk/reward profile of your trade.

Straddles and Strangles

Let’s kick it up a notch, shall we?

Opening a straddle or a strangle is just as simple as opening a put or call spread, but this time you’re purchasing both a call and a put.

With a straddle, you are buying both a call and a put at the same strike (or in the case of a short straddle, you are selling both the call and put at the same strike).

Here is an example of a rather large straddle trade …

For a long straddle, your goal is for the underlying to move in one direction or another.

So if you think XYZ will move, but you aren’t sure in which direction, you could buy a 50-strike call for $2, and buy a 50-strike put for $2.

Your maximum risk is the $4 spent to open the trade, and once XYZ moves above or below the break even price (so above $54 or below $46), you will profit.

On the other hand, say you expect XYZ will wind sideways within a small range for the foreseeable future. In this case, you could sell a straddle by selling a 50-strike call for $2 and 50-strike put for $2.

Your premium received would be $4, and that is your maximum profit.

However, in this trade you do take on significant risk, because if XYZ rallies above or below the breakeven, you’re on the hook for the difference – so if XYZ falls to $25, your loss amounts to $21 (since you received $4 for selling the trade).

That’s why I typically don’t trade short straddles … I prefer to add a few additional legs for “insurance” by way of a butterfly trade (which we will cover at a later date).

Finally, a strangle also involves the purchase or sale of both a put and a call, but this time you are targeting different strike prices.

So in a long strangle, you would purchase both a call and a put.

Continuing our XYZ example, you might buy the 45-strike put, and the 55-strike call. This would cost you $2, and you would be looking for XYZ to move below $43, or above $57.

If you’re wrong, your maximum loss is $2. In this scenario, this is more expensive than simply purchasing a call or a put, but you’re able to profit in either direction.

A short strangle, as you can probably guess, is selling both a call and a put at different strikes.

Here’s a real-world example …

This, like a short straddle, is also quite risky, because a large move in either direction could mean you see significant losses.

However, with a straddle, your profit range is rather narrow. With a strangle, the underlying can move further in either direction, while your trade remains profitable.

However, since you’re probably selling further out-of-the-money (and therefore cheaper) options with a strangle, you may have to settle for less profit.

So in this case, you would sell the 45-strike put, and sell the 55-strike call, each for $1. 

Your net gain is $2 and you’re able to pocket the full amount as long as the underlying sidewinds within the break even range of $43 and $57.

One quick note (that we will get into more at a later date) is that each of these spreads can also be used to target profits other than through straight stock price movement.

For example, when you are buying premium (such as in a call spread or long strangle), you can also profit not only if the underlying moves, but if the perception of movement increases; that is, if the options implied volatility rises.

When you are selling premium, the opposite holds true. You want the value of the sold options to decrease, and thus, you want volatility expectations to decline.

Don’t worry about this if you are just starting out. It will start to make more sense as you become familiar with options pricing, and options Greeks (specifically vega).

We will go over more spreads soon … email [email protected] if you have any specific spreads you’d like me to go over, or questions about what we went over today!

Your Only Option,

Mark Sebastian