Spreads

As mentioned in the previous module on futures, spreads are a strategy that involves two contracts, usually buying one and selling another. The contracts are related, the risk is limited, as is the reward, and you profit from relative changes between the contracts.

One of the spread strategies with options is called the vertical spread, because it uses options in line vertically on the table of prices. These options expire in the same month, and have different strike prices. Here’s an example of a vertical spread. You buy a $50 call and sell a $55 call in AAA Mining, both with the same expiration date. This is a bull call spread, because you think the shares are going to increase in price. As the $50 call will be more expensive than the $55 call, you will have a net outlay to establish the spread of say $2. For this reason, it can also be called a debit spread.

If the shares don’t go above $50, you won’t exercise the $50 call and the $55 call will not be exercised against you, so you lose the option cost of $2 per share. If the shares went to $55, you would exercise your $50 and make $5 per share, giving a net gain of $3 per share. If the shares went over $55, you would exercise your call and the $55 call would be exercised against you, so you would still work out to $3 dollars per share profit. If price was between $50 and $55, you would be somewhere between $2 loss and $3 profit — at $52 you would breakeven.

The net result of all this is that your losses are limited to two dollars per share and your gains are limited to three dollars per share. You can be engaged in the market and make this profit from the share move even though you don’t have the money to buy the shares.

Protective Put

This is another bullish strategy, but limits risk against a decline in price. You buy, or go long on, the stock, and can profit from the expected increase in stock price. But you also buy a put option with the strike price at the purchase price. Buying the put means that the stock has to rise in value at least as much as the option cost for you to breakeven. Any increase in value above that is profit, so your profit is not limited.

On the other hand, if you have misread the situation and the stock falls below the purchase price, you can exercise the put option and sell the shares for what you paid for them, so your downside risk is limited to the price of the option.

You can also use this technique to protect your gains when you have a long stock position, but don’t want to sell yet. The price you pay for the put option is insurance against a downturn.

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