Ask a Broker
July, 2005
Q: I have heard a lot about option spreads but I am unfamiliar with them. Can you help me understand, and give me an example of how to initiate a trade?
Lind Plus Senior Market Strategist Adam Klopfenstein answers:
A: Option spreads are a great way to take part in an upward or downward trending market. The premise behind them is that they have defined risk and limited profit potential but can be used to get closer to the actual futures price of the underlying commodity. An example of an option spread in the soybean market, where outright options are very expensive due to the volatility, would be to buy the November soybean $7/ $7.60 bull call spread. Here you are buying the call option closer to the money ($7 call) and selling the option that is further away ($7.60 call). Part of the cost of buying the $7 call is "financed" by the sale of the $7.60 call. If you wanted to buy a $7 call option on the November soybeans outright, it would cost you 34 cents (each cent in the beans is $50), or $1,700 per option. The maximum risk is the $1,700 you pay (not including any commissions or fees) and the profit potential is infinite above $7 plus the 34 cents you paid for the option (breakeven is $7.34). However, if you initiated a $7/ $7.60 call spread, the cost would only be 15 cents, or $750. The advantage of a spread is that you can get closer to the underlying commodity price for less cost. However, the disadvantage is that your profits are capped at the difference between the two strike prices (in this case 60 cents, or $3,000 exclusive of commissions or fees).
While the profits are not unlimited as they are with an outright option, it is rare that a market goes straight up or down. A spread can offer a better chance of having your long option in the money as you can get closer to the underlying commodity for less out-of- pocket cost. While option spreads can be an effective way to play a market move up or down, there is a tradeoff if the market were to move past the further-out call. In this case you would miss out on any potential profits above the strike price that was sold to "finance" the closer-to-the-money call. This same example can be used to position an account for a move lower in price through a put spread.
This can be done by purchasing a put closer to the underlying commodity price, while selling a put further away from the current commodity price. If you need any more information or explanation on the use of option spreads please feel free to contact me.
Adam Klopfenstein is a Senior Market Strategist with Lind Plus. You can reach him at 800-266-0551 and via email at aklopfenstein@lind-waldock.com.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com. To submit a question for Ask a Broker, contact the editor at that address.
Futures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Refco Private Client Group believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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