One of the main questions I receive as a broker after presenting a futures option spread to a client is, “Why?” Traders want to know why they should be entering an option spread as opposed to purchasing or selling an option outright. This article will help to explain the Why behind entering an option spread.
Why Use Option Spreads?
Purchasing option spreads offer the ability to get involved in markets for less of a premium than if one were to purchase options outright. This is done by selling an option to help finance the purchase of an option. This is known as a debit spread. Option spreads also allow you to collect premium without having to sell a naked option, which carries unlimited risk. This is done by selling an option and then purchasing an out of the money option to help reduce risk. This is known as a credit spread. Let’s take a more in depth look at debit and credit spreads.
A Debit Spread is when a Trader purchases an option spread and the premium paid is debited from their account. This is just like when you use your debit card at the gas station and the cost of gas is debited from your bank account. Debit spreads offer an opportunity to get involved in the option market for less premium than purchasing an outright option. If a trader wanted to purchase an at-the-money gold call for September, it would currently cost $3,160. This might be more than a trader wants to spend to get involved in an option. However, if the trader has an area he thinks the underlying market will be at expiration, he can use a bull call debit spread to reduce the cost. If he thinks the underlying futures price will be at 1650 at expiration, he can purchase the 1615/1650 September gold call debit spread for a price of $1,460. The maximum risk on the trade is the $1,460 paid for the spread. The maximum profit, therefore, will be the difference between the strike prices minus the cost of the spread, or $2,040.
Option spreads also can come in handy when you think a market will not go somewhere. This is the perfect scenario for a credit spread. Let’s say a trader thinks the corn market won’t go below $6.50/bu. He could sell a naked put option at $6.50; however, this carries unlimited risk. The risk and reward of selling naked options has been characterized as “taking the stairs up and the elevator down,” in reference to account values. Credit spreads offer a defined risk with the ability to have a play on where you think the market won’t go. The trader can sell the December 6.50 put for $1800 and also buy the 6.00 put for $900 to help reduce risk. Then, the trader would collect $900 for the position. The maximum risk is the change in strike prices minus the premium collected, or $1600. If the futures price at expiration is above $6.50/bu, the trader will keep the premium initially collected.
These are just two of the ways traders can use option spreads. They offer great ways to get involved in the futures options markets with the maximum risk being known. To learn about these strategies in more depth, check out the following articles: