Understanding Spread Options and Spread Trading
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home | Free Options Trading Videos | Understanding Spread Options and Spr . . .

Understanding Spread Options and Spread Trading

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Spread option trading is carried out by buying an option and also selling an option of the same type for the very same stock. Using this method will help an investor to limit their risk. This is due to the fact that the investor will know the spread between the two options. But doing so, however, will also limit the investor's upside profits.

The primary aim of spread option trading is to limit potential losses. This method is defined as purchasing one option and selling another and thus limiting the overall risk to the investor since they will know the difference in expiration date or strike price – or both – between the two options. And, the difference between the two options is known as the spread.

There are a number of different strategies that can be used with option spreads. The primary techniques that may be carried out include vertical spreads, horizontal spreads, and diagonal spreads.

Vertical spreads are a type of option trading strategy in which the option that is purchased by the investor as well as the option that is sold both have the same date of expiration. The only difference is in the strike price of the two options. The reason that investors use this method of trading is because they feel that the price of the underlying stock will rise, however they also feel that the rise will not be very substantial.

Investors can also use the vertical spread option strategy if the price of the underlying stock is expected to drop. For example, bear put spreads are option spreads that are structured by purchasing put options that have a strike price which is near to the current market valuation on the share, and at the same time selling the same amount of put options at an exercise price that is below that of the options that were purchased.

Another type of option spread strategy is called the horizontal spread. These occur when the strike prices of two options are the same, yet they have differing expiration dates. This type of spread primarily is used to take advantage of the option's premium decay. With a horizontal spread, the investor will sell the closer option and subsequently purchase the further option. The investor will then close out the option position once the expiration date draws near.

Yet another type of option spread is known as the diagonal spread. Here an investor will purchase two options that differ in strike price as well as in their date of expiration. This type of option spread contains a large number of variables and is not recommended as a strategy for beginning options traders.

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