Feb 07, 2022 EducationalInvesting Strategies

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Now, I know many of you are wary of options. We’ve all heard stories about people who made and lost a fortune with options.

Unlike buying or selling calls or puts one at a time, spreads pair two offsetting option contracts on the same stock to create a trade with defined risk.

Today, I’m going to walk you through not only the basics, but also some key insights that even the most seasoned trader can use.

Buying a call option gives you the right to buy 100 shares of a stock at a selected price (the strike price) until expiration.

If you spend \$1 to buy a call option with a \$50 strike price, the payoff potential looks something like this:

The blue line represents the payoff of a \$50 strike call option that costs \$1. The x-axis shows the stock’s price, and the y-axis shows the profit and loss.

At \$50, the option is \$0 at expiration. Thus, your profit is -\$1. Once you get to \$51, you hit breakeven. After that, your profit continues to climb.

On the flip side, you could sell that same call option to someone else for \$1, and your payoff graph would look like this:

Here, the blue line represents the payoff of a \$50 strike call option that you sell for \$1. The x-axis again shows the stock’s price, and the y-axis shows the profit and loss.

This is the opposite of the previous graph; instead of buying the call option, you are selling it.

So, as long as the stock stays below \$50, you get to keep the \$1. Otherwise, your losses mount as the share price increases.

Guess what happens when you combine the two and simply adjust the strike prices?

That’s right. You get a payout graph that looks something like this:

Here again, the blue line represents your profit or loss as the stock’s price moves higher or lower.

In this graph, you combine a call option that you sell at \$49 with a call option that you buy at \$51. That’s why your profits are capped at \$1 once you get below \$49, but your losses are capped at -\$1 once you exceed \$51.

That’s why the blue line flattens out at \$49 and \$51.

This is exactly how option spreads work.

You take one long option and combine it with one short option to create a payout graph like the one shown above.

It’s really that simple.

By pairing two options together you create a “defined risk” trade where you cap your maximum possible gains and losses from the outset.

Option spreads are set up using the following rules:

1. Each option spread is created from a pair of options where one is short (sold) and the other is long (bought). This creates your guardrails for the spread.
2. The options need to be the same type (calls or puts) on the same stock with the same quantity. If you buy one call, you need to sell one call to offset it. If you sell two puts, you need to buy two puts to offset them.
3. All the options should have the same expiration date.
Spreads come in one of two varieties: debits and credits.

• Debit Spreads — You pay money to open the trade, and time works against you for out-of-the-money spreads.

Maximum Loss = Debit paid

Maximum Profit = Distance between the strike prices – Debit paid
• The strike price of the long put contract (the one you buy) will be higher than the strike price of the short put contract (the one you sell).
• You have a bearish bias and want the stock to finish below both of the strikes by expiration.
• If the stock gets above both strikes by expiration, you hit maximum loss.
• The strike price of the long call contract will be lower than the strike price of the short call contract.
• You have a bullish bias and want the stock to finish above both of the strikes by expiration to achieve maximum profit.
• If the stock gets below both strikes by expiration, you hit maximum loss.

Maximum Loss = Distance between the strike prices – Credit received

• The strike price of the long put contract will be lower than the strike price of the short put contract.
• You have a bullish bias and want the stock to finish above both of the strikes by expiration.
• If the stock gets below both strikes by expiration, you hit maximum loss.
• The strike price of the long call contract will be higher than the strike price of the short call contract.
• You have a bearish bias and want the stock to finish below both of the strikes by expiration to achieve maximum profit.
• If the stock gets above both strikes by expiration, you hit maximum loss.
In an out-of-the-money spread, the stock price is either below both of the call strikes or above both of the put strikes.

Let’s start by using the call credit spread example from above.

By looking at the two points where the blue slope flattens, we can tell what the strikes are and whether they are long or short.

The trade has a short call with a strike price of \$49 and a long call with a strike price of \$51.

The difference between \$49 and \$51 is \$2.

Looking at this chart, we can see the maximum loss of \$1 occurs when the stock goes above \$51 and the maximum profit of \$1 is achieved below \$49.

Why?

Because if the maximum loss is \$1 and the difference between the strikes is \$2, then to make the equation work, the credit received has to be \$1.

Now, here’s something that will blow your mind.

Take a look at the payoff chart for this put debit spread.

Notice any similarities to the call credit spread?

You should, because a put debit spread has the exact same payoff graph.

Despite the two having different option contract structures, they both want the same thing: a stock to finish below both of the strike prices by expiration.

Similarly, the payoff graphs for a call debit spread and a put credit spread look the same.

So if we were to create a put debit spread using this chart, it would work as follows:

• Long \$51 put
• Short \$49 put
• I paid \$1 to initiate this trade
• Maximum loss occurs above \$51 and is capped at the \$1 debit I paid to initiate this trade
• Maximum profit occurs below \$49 and is the difference between the strike prices minus the initial debit I paid