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The real benefits of options trading come with using options spreads. It's perfectly possible to make profits under any market condition by simply using a combination of the straightforward buying and selling of calls and puts, but if you can learn to use options spreads then you will discover many more opportunities to make profits.
An options spread basically consists of taking a position on two or more different options contracts that are based on the same underlying security. For example, if you buy contracts on a particular stock and also write contracts on that same stock, then you have essentially created an options spread.
They are primarily used for two specific reasons, limiting the risk and lowering the upfront costs of taking a particular position. However, there are many, many different types and some of them are very simple while others are more complex.
There are also a number of different ways that they can be classified. In this section we look at the main types, how they work, and how they are created. The following types of are all covered, along with some further information on them in your trading strategy. You should be aware that a number of them can fall into multiple categories. The simplest way to classify a spread is on what basic type of options are used — calls or puts.
Although some spreads can use a combination of both, most of them use either just calls or just puts. Any spread that is made up using only calls is known as a call spread, while one that is made up using only puts is known as a put spread.
Spreads can also easily be classified based on the capital outlay involved. When you create one you will either incur an upfront cost or receive an upfront credit. If you incur an upfront cost by spending more on buying contracts than you receive from writing contracts, then this is known as a debit spread.
If you receive an upfront credit by spending less on buying on contracts than you receive from writing contracts, then this is known as a credit spread. Another method for classifying spreads is based on the positions of the options relative to each other on an options chain.
Spreads that involve buying and writing contracts of the same type, same expiration date, and the same underlying security but with different strike prices would appear vertically stacked on an option chain and as such are known as vertical spreads.
Those that involve buying and writing contracts with different expiration dates, but the same type, same strike price, and same underlying security are known as horizontal spreads. Buying and selling options that have different strike prices and different expiration dates, but are the same type and same underlying security, is creating a diagonal spread. These involve options that have different expiration dates.
Horizontal spreads and diagonal spreads are both examples of calendar spreads, but there are other types too. They are essentially used to try and profit from differing rates of time decay between the contracts written and the contracts bought. This is applied to any spread that involves buying and selling differing amounts of options contracts, as opposed to buying an amount of contracts equal to the amount written. Typically they involve writing more contracts than are being bought, but the ratio can work either way around depending on what strategy is being used.
The different types of spread is a very important subject in options trading, as most strategies involve using them. There are many different types, and they are not all covered in this particular section. Instead, we have just covered the main categories, explaining their basic characteristics, and showing you how they can be used. We would suggest familiarizing yourself with the information in this section first, but for a more comprehensive list of the different types you can read our section on options trading strategies.
In that section we cover all the spreads you need to know with detailed information on how to use them. Types of Options Spreads The real benefits of options trading come with using options spreads. Section Contents Quick Links. Read more about Calendar Spreads Ratio This is applied to any spread that involves buying and selling differing amounts of options contracts, as opposed to buying an amount of contracts equal to the amount written.
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