One of the main questions I receive as a broker after presenting a futures option spread to a client is, “Why?” Traders want to know why they should be entering an option spread as opposed to purchasing or selling an option outright. This article will help to explain the Why behind entering an option spread.
Why Use Option Spreads?
Purchasing option spreads offer the ability to get involved in markets for less of a premium than if one were to purchase options outright. This is done by selling an option to help finance the purchase of an option. This is known as a debit spread. Option spreads also allow you to collect premium without having to sell a naked option, which carries unlimited risk. This is done by selling an option and then purchasing an out of the money option to help reduce risk. This is known as a credit spread. Let’s take a more in depth look at debit and credit spreads.
Debit Spreads
A Debit Spread is when a Trader purchases an option spread and the premium paid is debited from their account. This is just like when you use your debit card at the gas station and the cost of gas is debited from your bank account. Debit spreads offer an opportunity to get involved in the option market for less premium than purchasing an outright option. If a trader wanted to purchase an at-the-money gold call for September, it would currently cost $3,160. This might be more than a trader wants to spend to get involved in an option. However, if the trader has an area he thinks the underlying market will be at expiration, he can use a bull call debit spread to reduce the cost. If he thinks the underlying futures price will be at 1650 at expiration, he can purchase the 1615/1650 September gold call debit spread for a price of $1,460. The maximum risk on the trade is the $1,460 paid for the spread. The maximum profit, therefore, will be the difference between the strike prices minus the cost of the spread, or $2,040.
Credit Spreads
Option spreads also can come in handy when you think a market will not go somewhere. This is the perfect scenario for a credit spread. Let’s say a trader thinks the corn market won’t go below $6.50/bu. He could sell a naked put option at $6.50; however, this carries unlimited risk. The risk and reward of selling naked options has been characterized as “taking the stairs up and the elevator down,” in reference to account values. Credit spreads offer a defined risk with the ability to have a play on where you think the market won’t go. The trader can sell the December 6.50 put for $1800 and also buy the 6.00 put for $900 to help reduce risk. Then, the trader would collect $900 for the position. The maximum risk is the change in strike prices minus the premium collected, or $1600. If the futures price at expiration is above $6.50/bu, the trader will keep the premium initially collected.
Summary
These are just two of the ways traders can use option spreads. They offer great ways to get involved in the futures options markets with the maximum risk being known. To learn about these strategies in more depth, check out the following articles:
- Bull Call Spreads: An Alternative to Purchasing Calls by Drew Wilkins
- Bear Put Spreads: An Alternative to Purchasing Puts by Drew Wilkins
- Credit Spreads: Collect Premium while Keeping Your Clothes On by John Payne
Contact Daniels Trading
To open an account or request more information, contact us at (800) 800-3840 or info@danielstrading.com and mention .
Risk Disclosure
WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.
WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.
STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.
YOU SHOULD BE AWARE THAT IN THE EVENT YOU LIQUIDATED THE LONG SIDE OF A BULL CALL SPREAD AND STILL MAINTAINED THE SHORT OPTION POSITION, THEN YOUR RISK WOULD BE UNLIMITED.
The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.
Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.
© 2023 StoneX Group Inc. All Rights Reserved
