Option Trading Strategies - Using Vertical Spreads To Profit

Equity market traders utilize different option trading strategies depending on current market conditions and their goals with one stock options trading strategy being vertical spreads. When options expiration looms on the short term horizon, stock option traders take advantage of time value and the dollar for dollar change in intrinsic value as expiration nears. Using spreads, the option trader has an advantage by using puts and calls to offset each other, with one side being in the money while the other is out of the money.

Bull Spreads

The potential for increased returns exist with a bull spread if the underlying stock value is expected and does rise. This is one of the favored methods of options traders employing a spread methodology. By purchasing an option with a lower strike price and selling one at a higher strike price the trader is utilizing a bull spread strategy. It doesn’t matter if puts or calls are used, dealers choice.

For example: If the underlying stock is $38, the options trader can sell one $45 call and purchase one $40 call. Once the positions are executed and opened, ideally the stock’s price will increase in value for example, $44 per share. As this increase in share price rises, the $40 call is in the money and increases in value dollar for dollar. The sold short call is still out of the money and does not change in value and will most likely drop in value as time moves toward expiration. In this example on what makes bull spreads strategies popular among options traders is both sides of the spread will be profitable.

Bear Spreads

The bear spread is employed when the trader anticipates that a stock’s current value per share will decrease, either by technical analysis or based on fundamental reasons. Whatever the case, the trader suspects a pull back and wishes to capitalize on the downturn in stock price by employing a bear spread strategy. This tactic is the opposite of the bear spread in which the options trader buys a higher priced option and sells a lower priced stock option.

For example the trader may open a bear spread by employing call options. The trader will sell one call option with a strike price of $45 and purchase one call option at a strike price of $50. In this example, the underlying stock’s current market price is $47 and the trader suspects the stock price will soon be decreasing, based on whatever criteria he has used to reach this conclusion. Since he sold short a call at a strike price of $45 that is in the money, the value of the sold call will increase dollar for dollar as the stock’s price decreases as anticipated. This example is the exact reverse of the bull spread with the only difference being market direction of the underlying stock is going down rather than up.

There are many different option trading strategies available to the options trader. However, options are derivatives which obtain their value from another instrument, in this case, the underlying stock in which they are associated. Unlike stocks which will always retain some value, stock options are time sensitive. They have an expiration date and will cease to exist at some point in the future. Many options traders have a tendency to focus on profit potential while not considering the risks associated with options trading. As is in anything associated with the financial markets, the larger the potential for profit, higher degrees of risks should be expected.

When utilizing option strategy it is paramount the trader completely understand the method and how the strategy is designed to be implemented for potential profit. Money management is one of the most important, if not the most important aspects of options trading or any form of trading for that matter. Far too many traders across all financial markets, stocks, options, futures and currencies focus more on profits than they do on risks and money management. A trader that develops a trading system with strong money management principles will likely go on to become a successful trader.

Stock options offer an added opportunity for potential profit and are an excellent instrument to increase the size of your portfolio. Before utilizing a stock option trading strategy, it is important that the trader understand the options market, it’s terminology, the attributes of options, the different options contracts i.e., puts and call, expiration, intrinsic value, time decay, time value and a myriad of other terms associated with the options markets. By employing differing strategies for differing market conditions, the stock options trader increase profits or protect his portfolio by using options as hedge should the market go against his positions.