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Types of Option Spread Strategies
Spread is an options trading strategy where a trader buys or sells multiple options of the same type (call or put) which have the same underlying asset but the expiration dates and strike prices or both may vary.
Depending on the nature of options included, there are three types of spread strategies in the market. Here are the spreads of different types −
Vertical spread strategy
Horizontal spread strategy
Diagonal spread strategy
Vertical Spread Strategy
Also called money spread, this strategy includes two options of the same expiry date but different strike prices. A vertical strategy is helpful in diminishing downside risk, but it also limits the upside trend in doing so.
Horizontal Spread Strategy
This strategy uses two options of the same strike price but different expiration dates. The objective of horizontal spread is to capitalize on time decay which is a measure of how much the price of an option goes down over time.
The options nearing their expiration dates are more susceptible to the time decay phenomenon than long calls and puts. Therefore, a horizontal spread strategy lets the trader use long term option if a short time one incurs a loss or looks likely to go worthless. This lets the trader offset some losses from the expiration of the short-term option. In fact, a trader can potentially earn a profit from a long-term option if the short-term one goes worthless.
Diagonal Spread Strategy
This spread strategy includes venturing into two options of the same type but with different expiry dates and strike prices. This strategy works like a horizontal strategy when there is a time decay but it also benefits from the option’s price for movements in prices of underlying assets.
Spread strategies rely on strike prices and differences in expiry dates to earn a profit. As strike prices may help call and puts to earn a profit, it is used as a means to earn some profit. For example, when the market price of the underlying stock is below the strike price, the trader may write the put option to earn premiums. Similarly, when the price of a call option’s underlying is above the strike price of the market, the trader can exercise the call option to earn profits.
Premiums can also be earned from the expiry dates too. Time decay lets the traders earn premiums as the value of an option goes down below the strike price means there are options to sell the put options for a handsome profit.
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