From the May 01, 2010 issue of Futures Magazine • Subscribe!

Top 4 options strategies for beginners

Bull & bear spreads
Bull call spreads and bear put spreads also are called vertical spreads because they occur in the same month and they have two different strikes. Unlike with the covered call strategy, your risk with the bull and bear spread strategies is more easily quantified, says Joe Burgoyne, director of institutional and retail marketing at the Options Industry Council.

In a bull call spread, you buy a call on the underlying asset while simultaneously writing (selling) a call on the same underlying asset with the same expiration month at a higher strike price. You should use it when you think the market will go up somewhat, or think it’s more likely to rise than fall (in other words, you have a bullish or moderately bullish outlook). Your likelihood for profit is limited, as is your risk, because the price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price, so you have less risk of losing the entire premium paid for the call.

In a bear put spread, you buy a put on an underlying asset while writing a put on the same underlying asset with the same expiration month, but at a lower strike price. You should use this strategy when you think the market will fall somewhat or is more likely to fall than rise, as you’re capitalizing on a decrease in the price of the underlying asset.

Calendar/time spreads
Another strategy used in options is calendar, or time, spreads. In a calendar spread, you establish your position by entering a long and short position at the same time on the same underlying asset, but with different delivery months.

“The point of this strategy is, time decay happens much more quickly the closer we get to expiration. The theory is that when you short the front-month option, you’ve got that quickly-evaporating time premium working with you, faster than the decay in the further out option that you bought,” Burgoyne explains. “Just like the call and put spreads, you’re paying a debit for the spread and the further out you go in time, the bigger that debit’s going to be. You’re looking for a stock at expiration to be at the strike that you have put this spread on.”

The further out you go in time, the more volatility you buy in the spread. Burgoyne notes that if you pick an out-of-the money strike and the maximum spread, for this to work to your benefit the underlying has to go up to that strike for this spread to be at its widest point of expiration. “If you pick the at-the-money strike, you want the [underlying] to hang out around that strike, and if you pick the in-the-money, you want the [underlying] to go down. You are long volatility in this spread. You want to be cognizant of volatility levels,” he says.

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