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All You Should Know About Vertical Spreads And Synthetic Options Spreads

25 Sep 2023

Introduction:

Derivatives are investment instruments that derive their values from underlying assets. Futures and options (F&O) are derivatives whose values are derived from underlying stocks and share market indices. They allow you to earn superficial returns with limited capital requirements. 

However, options trading entails higher risks than stocks and other equities. It’s because they come with pre-determined expiry dates, and their values fluctuate rapidly between the issue dates and expiry dates. 

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Several options trading strategies can be deployed to minimise risks and maximise profits. This article discusses two of the most common options trading strategies – vertical spread and strangle options spread. Continue reading to know in detail about them.

Understanding options trading

Before you can start learning about options trading strategies, you must know what options trading is. Options are contracts that give you the right (but not the obligation) to purchase or sell underlying securities at a pre-determined price (known as the strike price) on or before a fixed date (known as the expiry date).

When you buy an options contract, you must pay the seller a premium. The value of the premium keeps on fluctuating till the contract’s expiry, depending on several factors like the underlying asset’s price, market volatility, time decay, and the interest rate. 

You can buy or sell options contracts as many times as you want before expiry to make gains from premium fluctuations. When you have a bullish perspective on an underlying stock, you can buy a call option, and, when you have a bearish perspective on an underlying stock, you can buy a put option.

Options trading strategies

Trading in options is highly risky. If you aren’t diligent enough, you can incur considerable losses. That is why you must use specified options trading strategies to limit your losses and maximise profit potential. The two most common options trading strategies are:

  • Vertical spread

In the vertical spread options trading strategy, you need to buy one call or put option and sell another option (same as the first one) with a different strike price. Both options must have the same underlying asset and the expiry date. This strategy is known as vertical spread since it involves two options with different strike prices.

You can use the vertical spread options trading strategy to reduce your upfront cost for options trading and also limit your loss in the case of adverse price swings. This strategy further includes a variety of techniques, including:

  • Bull call spread

The bull call spread is helpful when you have a bullish view of an underlying stock. It involves buying an In-The-Money (ITM) call option and selling an Out-Of-The-Money (OTM) call option. The strike price of the OTM call option must be higher than the strike price of the ITM call option. 

  • Bear put spread

A bear put spread is the opposite of the bull call spread. It’s helpful when you have a bearish perspective on an underlying stock. It involves buying an ITM put option and selling an OTM put option. Here, the strike price of the OTM put option must be lower than the strike price of the ITM put option.

  • Strangle options spread

The strangle options spread is quite similar to the vertical spread strategy. It involves one short call option and one short put option with different strike prices. The strike price of the first option must be higher than the strike price of the second option. The underlying asset and expiry date should be the same.

For example, if you have purchased a call option, you can sell a put option, and vice versa. This strategy is known as the strangle strategy because the call and put options together with different strike prices create a strangle. It is a limited-profit strategy with a neutral market perspective. Hence, it is generally preferred when a trader foresees low volatility in the underlying asset.

To conclude

Both vertical spread and short strangle spread options trading strategies are handy under different market conditions. If you feel the market can exhibit high volatility in the upcoming days, you can use the vertical spread strategy to make limited profits with limited risks. On the other hand, if you feel the market will remain sideways, you can deploy the short-strangle spread strategy.

If you need a Demat account to begin your options trading journey, you can open it for free with Motilal Oswal.

 

Related Articles: How to Convert Trade And Open Positions | Learn All About The Dated Government Securities | Nuances of International ETF | What is trading on equity

 

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