There are many different ways to trade options, depending on the direction you think the market will move. One way is through spreads, which involve simultaneously buying and selling two options for the same stock. Investing in spreads is a great way to limit the amount of money you are putting at risk, but you’ll also cap your potential profit.
Let’s break it down.
A spread can mean lots of different things, depending on the context. When it comes to trading, for example, a spread is the difference between the price buyers are willing to pay for a stock and the price sellers are willing to accept for a stock (also known as the bid/ask spread).
But an option spread is an options strategy that involves buying and selling options at different strike prices and/or expiration dates.
There are a few different types of options spreads, but we’re going to focus on vertical spreads. A vertical spread is when the two options involved are of the same type, concern the same underlying asset, and have the same expiration date. So, for us, it’ll be spreads that are either both call or put options, involve the same stock, and end at the same time. The only thing to note here is that the two options involved in a vertical spread have different strike prices.
A vertical spread is created when options contracts are bought and sold simultaneously. They can be organized into two categories: Debit and Credit. And of those, you can either purchase a Bull spread or a Bear spread.
Vertical spreads can be ordered into a few different categories:
Bull spreads: Like the name, you’re bullish and hope to profit from the increasing price of the underlying stock
Bear spreads: Like the name, you’re bearish and hope to profit off the decreasing price of the underlying stock
Debit spreads: Involves buying a high-premium option while selling a low-premium option, requiring you to pay up front. All option spreads on eToro are debit spreads, which means you’ll have to pay for them through your funded account.
Credit spreads: Involves selling a high-premium option while purchasing a low-premium option, resulting in a credit in your account. These are currently not available on the eToro platform.
The main reason you might consider a vertical spread is simple: You have limited loss potential. Because you’re buying one option and selling another, your overall cost is lower.
However, the tradeoff is that your profit potential also becomes limited.
This is also why you might want to consider a spread if you think the stock will move only slightly — your profit is limited, but you don’t expect the stock to move all that much anyway, so that might be all you’re looking for.
How option spreads work
Let’s say you wanted to invest in smart toaster manufacturer Toastr (TSTR). Instead of buying the stock directly, you could purchase a call option, which would be a lower-cost investment that could result in a nice profit if the stock moves up.
But what if you want to risk even less of your money on your options contract? You could turn your investment into a spread (specifically a bull call spread), and sell a different call option for TSTR. Taken together, buying one call and selling another would result in the completion of a spread, with the cost of the more expensive call option you bought being offset by the call option you sold.
The maximum loss in a bull call spread is the premium you pay — in this case, the premium of the call you bought, minus the premium of the call you sold.
To calculate the maximum profit you can make from a vertical debit spread, simply multiply the difference between the two strike prices by 100 (remember, options contracts are per 100 shares) and subtract the number you got for maximum risk (the difference in premiums). So, to sum up:
Max loss = Difference in premiums
Max profit = (Difference in strike prices x 100) – (Difference in premiums)
No matter where the stock ends up, your result will be between these two numbers. Keep these equations in mind as we move into our examples below.
How to choose an option spread
eToro offers two vertical spreads on the platform: bull call and bear put. Let’s start with bull call spreads. (You can find a refresher on put and call options here.)
Bull Call Spread
A bull call spread involves two option transactions:
- Buying a call option
- Selling a call option with a higher strike price
When you just buy a call option, you have unlimited profit potential. By selling a call option against your purchased call option, the overall cost of your position is reduced, which means there’s less loss potential. But, as we mentioned before, the tradeoff is that this options strategy has limited profit potential.
You might use this strategy if you are looking to lower the amount of money you put into your investment or if you believe a stock will go up only slightly before the expiration date. This is because while the spread limits your gain, if you only think the stock is going to move slightly, you get the benefit of that move, while risking less in the cost of the premium.
Let’s go back to that Toastr example — say you think the stock price is going to go up from its current value of $60, but you’re not sure how much it’s going to go up by. A bull call spread would involve buying one option and selling another.
Buy call option for of TSTR
Expiration date: 1/1
Strike price: $50
Option cost (premium): $1,000
Sell call option for TSTR
Expiration date: 1/1
Strike price: $70
Option cost (premium): $500
In this example, when choosing the two options, you’d pay $1,000 for purchasing the $50 call and you would receive $500 from selling the $70 call option. Your total net debit is $500 from this option spread — that’s the price of your spread, and your maximum loss*.
Max loss (and net debit, AKA the price of your spread) = $1,000 – $500
If you use the equation we mentioned in the last section, you can also find your maximum profit.
Max profit = (($70 – $50) x 100) – ($1,000 – $500)
= ($20 x 100) – $500
= $2,000 – $500
= $1,500
Let’s say your expiration date rolls around and the stock is selling for $70. You’d earn $1,500 from the call option you bought, and $0 from the call option you sold. After subtracting your net debit ($500), your overall gain for the spread is $1,000.
If you had just purchased the first call, your profit might be higher, but you’d have spent more initially. If you had bought just the second call, you wouldn’t have made any profit. By creating a spread, you have capped both your maximum loss and your maximum profit.
Bear Put Spread
This spread is basically the reverse of the bull call spread and could be used if you think a stock will drop in the future:
- Buy a put option
- Sell another put option with a lower strike price
The maximum amount you could expect to lose is the amount you paid for the option. Once again, the maximum profit potential is the spread between the two strike prices minus the premium paid. Let’s say you think TSTR may actually decline from $60 in the future. A bear put option spread may look like this:
Buy put option for of TSTR
Expiration date: 1/1
Strike price: $70
Option cost (premium): $500
Sell put option for TSTR
Expiration date: 1/1
Strike price: $40
Option cost (premium): $200
In this example, the maximum amount you would lose is $300, or the difference between the two premiums (this is also the price of your spread)*. The maximum profit would be:
Max profit = (($70 – $40) x 100) – $300
= ($30 x 100) – $300
= $3,000 – $300
= $2,700
Once again, if you had just purchased one put, your total profit could have been higher, depending on the strike price. But you would also be risking a larger investment ($500, as opposed to just $300 with this spread).
Trading spreads on eToro
Want to start trading spreads? The eToro interface makes it simple.
Once you find a stock you’re interested in on the eToro app, click “Trade.” There, you’ll have the choice to invest in a spread. Keep in mind you’ll need to get approval to trade spreads via a margin and options agreement (you should be prompted when you select a spread).
Once you pick the type of option that you want, pick the date you expect the option to move by (the expiration date) and the price past which you expect it to move (the strike price). You’ll also be able to view the option’s trade risk, bid price (current value), daily change in price, or breakeven point.
Select the number of 100-share contracts you’d like to purchase, and you’re all set! Once you purchase your spread, you have the option to wait until the expiry date or trade your option to someone else. Learn more about how to trade on eToro here.
Conclusion
The experience in eToro also makes it easy and straightforward to build a spread strategy that works for you while limiting the amount you may lose and the amount you may gain*.
To explore options on eToro , click here.
*There are certain edge cases in which you may be exposed to greater loss than your initial investment. Although these instances are rare, they can occur.
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