What is an options spread and what are the types of spreads?
An options spread is a strategy that involves taking multiple positions on options contracts, typically by buying and selling options of the same underlying security but with different strike prices and/or expiration dates. The main types of spreads include:
- Horizontal Spreads/Calendar Spreads: These spreads are formed by trading options of the same underlying security, with the same strike price, but different expiration dates.
For instance, imagine a stock named ABC trading at ₹50. An investor might buy a call option with a ₹50 strike price expiring in two months and simultaneously sell a call option with a ₹50 strike price expiring in one month. If ABC remains near ₹50 as the first expiration date approaches, the sold option could lose value faster than the bought option, potentially resulting in a profit.
- Vertical Spreads: Vertical spreads involve trading options of the same underlying security and the same expiration date, but with different strike prices.
Let's say, for the same stock ABC at ₹50, an investor might buy a call option with a ₹50 strike price and sell a call option with a ₹55 strike price, both expiring in one month. This strategy can create a more controlled risk-reward scenario.
- Diagonal Spreads: These spreads combine elements of both vertical and horizontal spreads. They involve trading options of the same type and underlying security, but with different strike prices and expiration dates.
Using ABC stock, an investor might buy a call option with a ₹50 strike price expiring in two months and sell a call option with a ₹55 strike price expiring in one month. This can maximize potential profits by leveraging both price movement and time decay.
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