An option is a means of investing in the stock market. It gives the investor the opportunity but not the obligation to purchase stock at the option strike price within a given time frame. An investment in options can control stock without owning the stock. A spread option is a means of reducing the risk associated with options by investing in two options that are similar but differ in some key aspect. Each option can offset the potential losses of the other.
A single option provides gains if the market moves in the predicted direction. The market price of the underlying stock must go up during the option period for the call option to gain value, and it must go down for the put option to gain value. When investors buy two offsetting options, movements in the underlying stock value will yield gains if they are positive, neutral, or slightly negative. A bullish strategy implies the investor believes the stock value will rise, while a bearish strategy implies the opposite.
Using a spread option as a consistent investment strategy offers several advantages. There is a lower cost of trade: the sold option offsets the cost of the buy option. Overall risk declines. For bullish trades, the breakeven point decreases. The principal disadvantage is that the profit potential is capped and commission costs may be higher.
A spread option separated by a difference in strike prices is a vertical spread. A bull call spread involves buying a lower strike call and selling the same number of higher strike call contracts, all at the same expiration date. This spread option works well as a long-term strategy with options expiring six or more months in the future. In a bull put spread, the lower strike put is bought along with selling the higher strike put. Short-term income strategies are often based on bull put spreads.
Calendar spread refers to buying options with different expiration dates. If a stock is generally believed to be moving steadily in one direction, buying options with a calendar spread is one way to reduce long-term risk. A chicken strangle is a spread variation in which a call and a put are both bought at several strike prices away from the current stock value. This technique often works well for highly volatile stocks. One option goes to zero while the other is sold.
The term spread has come to cover many other risk-reduction strategies. In the futures markets, commodities can be bought and sold at different processing stages. A crack spread option refers to the difference in value between crude oil and refined products. Crush spread option compares the value between soybean futures and soybean oil and meal. Processors can reduce the risk of production cost variances, and investors can potentially share in the profit margin by trading these assets.