The Flexibility of Options

Options have dozens of uses beyond the basic strategies. They can be used to open spreads, for example. These are strategies consisting of opening two or more different options at the same time and on the same underlying stock, but with different strikes, or different expiration dates, or both.

There are three different ways to create a spread. The first refers to different strike prices (vertical spreads). These are spreads opened on the same expiration month but with different strikes.

Key Point

Spreads can be designed with varying levels of risk based on perceptions about the direction stock prices are most likely to move.

The second type is the opposite, with options at the same strike price but different expiration months (horizontal spreads), also called calendar spreads).

The third type of spread has different strike prices and expiration dates (diagonal spreads). These are a combination of the vertical and horizontal spreads.

Spreads come in a great variety of forms involving only calls, only puts, or both; and consisting of long positions only, short positions only, or both long and short positions.
The construction of the spread defines its level of risk as well as the maximum and minimum levels of profit or loss that can be earned at given price levels.

Key Point

Spreads can be constructed using calls only, puts only, long positions, short positions, and combinations of both. They are among the most flexible of option strategies.

Another expanded form of options is a series of strategies known as straddles. These consist of opening call or put positions with identical strike prices and expiration dates. They may be long or short. Long straddles require paying out cash in the hope that one side or the other (call or put) with gain enough value to surpass the cost of the straddle. A short straddle produces income but involves greater risks as well.

Straddles, like spreads, can be quite complex and involved in their construction. They are designed to create limited profit or loss ranges in price, based on the trader's belief about the most likely direction of price movement in the underlying stock.

Key Point

Straddles invariably involve a limited profit potential, limited loss potential, or both.

A final use of options is the creation of a synthetic position. This is a combination of options that mirror the price changes in other positions, such as stock. For example, a synthetic stock position will change by growing by one point when the underlying stock price rises, or falling by one point when the underlying stock price falls.

Options are flexible tools that can be used in many different ways and at different risk levels. The danger to a novice trader is in entering option positions without fully understanding the risk that is involved. With experience, traders learn that options can provide many levels of usefulness from speculation to advanced portfolio management.

A Sensible Approach to the Market proposes a method for taking ideas from both investing and trading strategies to build a sensible approach to the stock market that works best for you based on experience, resources, and risk tolerance.
By Michael C. Thomsett

Copyrighted 2019. Content published with author's permission.

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