One of the benefits of using the options market is increased flexibility. If an investor goes directly to the stock market, for example, he or she has limited trading possibilities: basically, either go long or go short. This doesn't allow for much nuance and does not give a lot of opportunity to limit risk.
Not so with the option markets. In option trading, it is possible to combine various positions in order to take advantage of an expected move in an underlying asset, while still limiting risk and achieving increased flexibility. This can be done in a relatively basic way - combining the buying and selling of puts and calls in a way that forms a coherent strategic play. This makes options spreads powerful trading strategies. Using these relatively simple combinations of options can make for a far more nuanced trading approach.
In an options spread, an investor buys and sells the same number of the same type of option on the same underlying asset. However, the strike prices or expiration dates for the options are different.
Essentially, the investor is taking both sides of a trade, both buying and selling the same type of option (either a put or a call). However, by altering the strike price or the expiration date on either side of the trade (or both), the spread can be built to take advantage of various types of market conditions, while limiting the risk.
1) Vertical Spread: These spreads are constructed by buying and selling puts or calls that have the same expiration date, but with different strike prices.
2) Horizontal Spread: These spreads are constructed using the same strike prices, but with different expiration dates. These are basically the opposite of the vertical spread, varying the expiration date rather than the price.
3) Diagonal Spread: This combines the attributes of a Vertical Spread and a Horizontal Spread. The options involved have both different strike price and different expiration dates.
Read further on spreads, including the differences between Bullish Spreads and Bearish Spreads, in the next two sections.
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