The Benefits of Trading Option Spreads

The Benefits of Trading Option Spreads

The Benefits of Trading Option Spreads

More & more investors are using stock option spreads to increase their profit potential while lowering risk parameters. The most obvious benefit of trading an option spread is lowering risk, while still maintaining high returns. Whether buying the spread or selling the spread, the exact amount of risk (amount of maximum loss) is finite. Buying a stock and selling a covered call option requires much more capital, and the net losses can be far greater. For example, Trader A is bullish on stock XYZ. Trader A buys a bullish call spread for $3. This can result in a $7 maximum gain or a $3 maximum loss, or anywhere in between (for a ten-dollar strike spread). Trader B is also bullish on XYZ stock. Trader B buys the stock and sells the covered call. In this example, say tragedy strikes and the stock drops 50%. Trader A loses $3, not a big deal. Trader B loses his shirt, suffering a heart-wrenching loss.

A further benefit of trading option spreads is time decay (also referred to as theta'). Since all options are temporary investments, all options are in a constant state of decay. As expiration nears, option values decay faster. If an investor has an option spread, he/she is both long and short options, so both the long and short options will decay, often nullifying the true time decay risk.

The benefit of straight buying a call option or put option is leverage, the cost of this leverage is risk of loss in the value of the option. It is said that 70% of all options expire worthless. The best way to offset this risk is to buy an option while simultaneously selling an option of a different strike, hence the option spread.

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