How to Trade Option Spreads
A option spread is the simultaneous purchase and sale of an equal number of option contracts at different strike prices. A call option is the right to buy the underlying stock at a specific price called the strike price. An trader who buys a call option wants the underlying share price to climb above the strike price. A put option gives the holder of the contract the right to sell the stock at the strike price. A put-option buyer desires the value of the underlying stock to go down. A stock will have options with different strike prices above and below the current stock price.
Sellers of option contracts receive the premium or cost of the option and are required to deliver the stock (call option) or buy stock (put) at the strike price if the option is exercised by the buyer. Options are in-the-money if the stock price is above the strike price for calls and below the strike price for puts.
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Instructions
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Select a stock that you believe will increase in value. On the quote screen of your online stock broker account, enter the stock symbol and select the option chain.
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Narrow the option chain down to just call options and near-the-money strike prices. Select an expiration date one to three months in the future based on your evaluation of the future stock price.
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Select spread from the option screen strategy menu. An option with the lower strike price will be purchased and one with a higher strike price will be sold. The option chain screen will let you designate these two options.
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Select trade to complete the purchase of the spread. This spread is a bull call spread and is initiated as a debit or cost. You should place the trade as a debit or limit order midway between the bid and ask quotes. An equal number of contracts should be bought and sold.
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The maximum profit on a call spread is the difference between the strike prices minus the debit paid. Maximum profit is achieved when the underlying stock price exceeds the higher strike price. When this occurs, close out the position by selling the low strike options and buying back the high strike options.
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If the expiration date is approaching and it does not appear the stock price will exceed the high strike price, close out the spread for any credit between the bought and sold options.
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Tips & Warnings
A bear put spread is used if the stock price is expected to fall, using put options instead of call options. Calculate the expected profit and debit cost using different strike prices around the current share price to determine the spread with the best potential for profit. Some online option broker websites will automatically populate the order screen with selected options when you select a strategy. Make sure these are the contracts you want to buy and sell.
Spread option strategies can result in a 100 percent loss of funds invested if the underlying stock does not move as predicted. Sold-option contracts are subject to exercise anytime up to expiration and will be automatically exercised if they are in the money at expiration. Close out any vulnerable positions before the expiration date. An option contract is for 100 shares of the underlying stock. The cost of the option is 100 times the option price.
