Most investors only see the stock market as a one-way street. If the stock or fund price rises, they make money. If the price falls, they lose. While this approach is easy to understand, it doesn’t always suit the individual. Many people would like to profit in both directions, apply leverage or put the odds in their favor. While equity investments can’t provide this opportunity, the options market can. Let’s explore how option spread trading can allow you to have it your way.
What is an option spread?
You may have heard of calls and puts and know that buying a call will capitalize on a rise in the price and vice versa for a put. However, you may not be familiar with the idea that options can be both bought and sold together.
Buying options allow you to pay a premium for unlimited upside potential. That may sound attractive, but it does come at a cost. That cost is time decay. Every day the option loses some of its value until expiration. As a result, the stock price must rise enough to compensate for the lost value. This means that buying options has a lower probability of success than buying stock but has significant leverage that can provide large winners.
Selling options allows you to make money each day as the premium you collected wastes away, allowing you to buy back your option at a lower price. In this case, the time decay works in your favor and helps provide a higher probability of success than owning the stock. However, your return is limited to the premium you received.
In the case of selling options, you’re in control of how often you make money by choosing how close you want to sell to the current stock price. By selling further away, you have a higher probability of making money but will be paid less premium.
A spread trade typically combines buying and selling a call and or put. By packaging options together, you can achieve the risk-reward and probability combination that best fits your view of the stock price and desired trade profile.
Intro to in/out spreads
We teach many different spread strategies at TheoTrade, but one of the most popular is the in/out spread. One of the reasons this strategy is so popular is that it is a directional trade with limited risk and excellent return potential on a given trade.
An in/out spread is constructed by buying an in-the-money (ITM) option and then selling an out-of-the-money option (OTM). A call vertical in/out spread is considered a bullish trade, and a put in/out is bearish.
For example, if you’re anticipating that the stock price is going to rise, you would buy the strike price just below the current price and sell the strike that is higher than the current stock price. This spread typically has a $2 spread between the strike bought and sold. For higher-priced stocks, the spread may have a $2.50 or $5 spread between them.
For bearish opportunities, you would buy a put at a strike price that is just above the stock price and sell a strike price that is just below the current stock price. When setting up these types of trades, you want the strikes to be approximately equidistant from the current stock price.
In/out pricing and probabilities
The pricing of the in/out spread is pretty straightforward. Since the spread is straddling the stock price, there is a 50% probability of making or losing money if held until expiration. That means the cost of the spread will be approximately 50% of the spread width.
For example, if the spread between the strikes is $2, you should pay around $1. This understanding is important since not every spread opportunity is optimally priced. Implied volatility skew can significantly impact pricing. While skew is an important concept to understand, the application is in the pricing. For a $2 spread, you would never want to pay more than $1.05 per share or $105 per contract.
If you were to pay $1 for a $2 wide in/out spread, your maximum profit is, therefore, $1. This provides a return potential of 100% by expiration and is achieved by the stock price moving $1 in your favor. However, the TheoTrade approach increases the probabilities significantly by closing the trade at a 55% return or higher. If the spread were sold at $1.55 instead of $2, this would provide a $0.55 gain since you paid $1 upon entry.
The combination of incorporating strikes that straddle the stock price and closing at a 55% gain limits the impact of time and implied volatility and increases the probability of success of just going long or short the stock. Pairing the in/out spread strategy with TheoTrade’s proprietary Expected Move Indicator can be a powerful combination!
Call in/out spread example
The long call vertical is constructed through the buying and selling of a call for the same expiration. The driver in this case is the long call option, which is more expensive and is the lower strike price of the spread.
- Max Loss—Initial net debit
- Max Gain—Spread width minus the initial debit
- Breakeven—Initial net debit plus the long call strike
Put in/out spread example
The long put vertical is constructed through the buying and selling of a put for the same expiration. The driver, in this case, is the long put option, which is more expensive and is the higher strike price of the spread.
- Max Loss—Initial net debit
- Max Gain—Spread width minus the Initial debit
- Breakeven—Initial net debit minus the long put strike
For many investors, there is a feeling of being trapped in the long-only box where everything is always at risk. Incorporating option spread trades, like the in/out spread, can be a great way to break out of the box and expand your trading opportunities. By limiting risk and increasing the potential return and probabilities, you’re placing more in your favor. While in/out spreads are just one example of an option spread trading strategy, it can represent an overall enhancement to your portfolio.