The ability to manage risk vs. reward precisely is one of the reasons traders continue to flock to options. While an understanding of simple calls and puts is enough to get started, adding simple strategies such as spreads, butterflies, condors, straddles and strangles can help you better define risk and even open up trading opportunities you didn’t have access to previously.
Although it may seem daunting at first to put on these strategies, it’s important to remember most are just a combination of calls and puts, says Marty Kearney, senior instructor at CBOE Options Institute. “These names came about so that people who were phoning in orders to trading desks could convey very quickly what they wanted to do. These are all pretty basic strategies, just taking things up a notch.”
A call gives the buyer the right, but not the obligation, to buy the underlying asset at the purchased strike price. A put gives the buyer the right, but not the obligation to sell the underlying asset at the purchased strike price.
An options spread is any combination of multiple positions. This can include buying a call and selling a call, buying a put and selling a put, or buying stock and selling the call (which would be a covered write). For our purposes, we are going to look more closely at a vertical call bull spread, which is used if we expect the price of the underlying stock to rise, although these same principles can be applied to bull put spreads, bear call spreads and bear put spreads.
Fundamentally, vertical spreads are a directional play, says Joseph Burgoyne, director of institutional and retail marketing for the Options Industry Council, which means the investor needs to have an opinion whether the underlying is going to go up or down. Additionally, while they have limited risk, they also have limited reward.
Kearney explains, “What I’m looking at is I want to control the stock, and I think we’re going to a certain dollar amount. I’m willing to give up anything above that,” he says. For our example of a vertical call bull spread, he uses a stock trading at $63 that he believes will go at least to $70.
You simply could buy either the stock or a single call, but by purchasing the bull call spread you are able to better limit your risk. In Kearney’s example, we put on the 60-70 vertical call spread, which consists of buying one in-the-money 60 call and selling one out-of-the-money 70 call. Because we sold the 70 call, we limit the maximum value of our spread to $10 (minus commissions), but we lower our breakeven for the trade because of the credit we earned selling the 70 call. Additionally, our loss is limited to the cost of the spread.