You may already know that you can use options for hedging and speculation, but did you also know they can help increase your stock trading results?
Options traders tend not to hold as many positions as the average stock trader. This means they spend less time worrying about their open positions. Instead of constantly checking on execution prices or market conditions, options traders simply manage those one or two positions that they might have active at any given time. They can do this because of how effective it is to use option spreads instead of buying each option contract for every strike price needed in a strategy.
What is an option spread?
It’s just like it sounds – the simultaneous purchase and sale of options within the same underlying asset. Typically this means you are trading options at the same strike price, but not always. If you were to buy one put option contract for every call option contract you sell, it would be called a “credit spread” because you could theoretically pay for all of those contracts without any money leaving your account.
This is the simplest and most conservative type of spread using options – long/short, bullish/bearish on the same underlying asset and expiration date (this will be important later). However, more complex and aggressive spreads can make more money if executed correctly: “debit” or “bull spread.”
Debit spread
An options strategy known as a debit spread, or a net debit spread, is when the investor purchases and sells options of the same class with different strike prices, requiring a “debit” to be paid out. The result is a negative charge to the trading account.
Bull spread
A bull spread is an options strategy that aims to profit from a modest increase in a security or asset value. The Option with the lower strike price is acquired, and the one with the higher strike price is sold, regardless of whether it’s a put or call.
Buying a higher number of contracts than sold sends risk profile up as well as profit potential up. Typically used when you believe the underlying stock price will climb “debit” or “bear spread.”
Short higher number of contracts than bought sends risk profile down as well as profit potential up. You typically use it when you believe the underlying stock price will fall “diagonal spreads.”
Long one expiration date, short another expiration date, on different underlying assets (you are taking advantage of differing option contract prices) can be more complex for beginners “iron condor.”
Buy put and call options on the same asset with different strikes/expiration dates but share a common underlying asset.
Iron condor strategy
It’s called an iron condor because while both sides are losing money, they are offsetting each other so the same contract month on the same underlying stock. The choices for spreads are almost limitless, which is why they’re ideal for traders looking to limit risk while at the same time increasing profit potential (if done correctly)—many times, having too many options contracts open at once will lead to the trader panicking and making irrational decisions that end up costing them money.
An option spread can help ease this problem by managing risk across several option positions instead of one single position.
Option spreads can be used in two primary ways:
1) To generate income (non-directional strategies)
2) To hedge existing positions (directional strategies)
Non-Directional Option Spreads – For income generation purposes. These are also known as “credit spreads” and “bull spreads”.
Directional Option Spreads – For hedging purposes. These are also known as “debit spreads” or “bear spreads”. Visit this site to find out more.
Bottom line
Options are usually associated with a high degree of risk, but traders have a variety of simple techniques that entail little danger. Even risk-averse traders can use options to boost their overall profits as a result. However, it’s critical to grasp the potential consequences of any investment so you know what you could lose and whether the potential gain is worthwhile.