What Is an Option Spread?

If you are investing in the stock market, you should learn about option spreads. These mitigate the risk you take when buying shares. Before we can understand what an option spread is we first need to be clear on what an option is.

Options

An option is basically a contract that gives the buyer of the option the right to buy or sell an underlying security on a specific date for a specific sum or amount. Please note that the buyer of the option has the right to buy or sell but is not under any obligation to do so. That is, the buyer of the option can let the option expire without exercising their right to buy or sell the underlying security. Options are classified as derivatives as they derive their value from underlying assets such as stocks or real estate.

Option Spread

An option spread has two legs. One option is a buy one and the other a sell option. These two balance each other and act as a hedge against each other. This way the investor will be able to mitigate their risks. With the lowered risk, come lower profits. You will be required to purchase two options for every investment decision you make.

The spread will vary depending on time or value of the underlying stocks. When the strike price varies, it is called a vertical spread. When the strike date varies it is called a horizontal spread. A diagonal spread is one in which there is a mixture of vertical and horizontal spreads, that is when the strike price and strike date vary.

Hedging the Market

An option spread is used as a hedge against unforeseen rises or falls in stock prices. A spread that is designed to profit from a rise in prices is called a bull spread whereas a spread that is designed to profit from a fall in prices is called a bear spread. So, even when constructing a spread, the market operator or player has to bet on whether the market will be bullish or bearish in the short or long term.

Long term option spreads are called LEAPS. Even as options are used to mitigate the risks of stock market trading, option spreads are used to mitigate the risks of trading in options. However, you need to understand the full workings of the stock market and the options market before you venture into the territory of option spreads. Derivatives are very complex and you can lose a lot of money if you are not careful or do not understand how the system works.

If properly used option spreads can reduce risks to a greater extent than the possible reduction in profits or rewards. This means that option spreads offer the potential for a great return on investment. For this, however, one needs to study option spreads correctly. To benefit from the full power of options trading, you need to understand the workings of option spreads.

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