Option Strategy # 3 - The Spread

While I accepted and understood how a spread works I did not really comprehend the true power and flexibility of this strategy until today.

Technically the spread can do a few things:

1) it can make money if the price goes up....but a typical call can do that

2) it can make money if the price does nothing...calls depreciate in that case

3) it can make money at the moment of executing the paired trade...the put sold is worth more than the call bought

4) it can reduce the cost of a trade...the put sold offsets the cost of the call bought.

The third is my target but this takes some work to find puts that are valued higher than the call and still OTM enough that it is not likely to get "put" before expiry. From what I understand not many options get exercised before expiry unless there is some great move that needs to be taken advantage of at the time...even then 75% or better expire worthless anyway. This is the credit spread.

Buy the OTM call with a near term expiry and sell the same expiry OTM put. The call depreciates if the price does nothing and can expire worthless. The put makes money the instant it is sold, which is why a higher priced put is nice. Of course if the stock price goes up and the call appreciates, even better as then the put has already made money and the call is making even more.

This leads to the strangle as it is, basically, two spreads... one selling the put and the other selling the option bracketing the price and the potential price moves for the term of the options.

Jeff.