Option Spread Strategies
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Most investors are attracted to binary options market because of the leverage the traders enjoy and also the ability to make greater returns on the capital invested. The problem traders faced is that you can never be too sure of a trade no matter the strategy you used. Markets are subjected to volatility and hence you cannot control some of its action, the best way to deal with it is to try and minimize your risk or spread it and thats the reason many traders are adopting option spread strategies for their trades.
Binary option spread strategies are strategies whereby a trader initiates a purchase and sale of options of the same class on the same underlying financial instrument but with different expiration time and different strike prices. Traders do this in order to limit the amount of risk they are exposed to during a trade; they also do it in order to reduce the amount of capital that is required to enter a position in the market. Not very many people know how option spread strategy works, no wonder option spreads made up of only a small portion of the total trades that takes place on an exchange. This is largely due to the fact that many investors especially those trading for themselves fail to adequately learn what a spread trade actually is and the advantages it gives a trader for risk management.
Binary options Spread Strategy Details and How it Works
Option spreads limits risk by combining 2 different option strike prices or expiration dates. It involves opening a position by purchasing and selling the same type of option (which is Call or Put). When a trader buys one option and sells another at the same time, he limits the risk he is taking on the trade since he knows the exact difference in either the strike price or expiration date between the 2 options. In fact, the difference between the two options is what is called spread and thats where this strategy derived its name.
The three main classes of option spread strategies include:
- Vertical Spreads
- Horizontal Spreads
- Diagonal Spreads
We will take a look at these spreads to know the difference and similarities between them.
A vertical spread occurs when a trader buys one option and sells another one but the two options have the same expiration date but with difference in strike price only.
Example: If a trader purchased a $40 November Call option and sold a $50 November Call Option, he created what is known as a Vertical Spread.
Horizontal spreads is also called Calendar spreads or Time spreads. This kind of a spread occurs when the strike prices of the 2 options bought and sold by a trader remains the same but with different expiration date. This is because options; which have time value associated with them, loses those premium value as time goes by and the value drops even faster as the options approaches the expiration date.
Diagonal spreads is the combination of both vertical and horizontal spreads. They occur when a trader purchased and sold 2 options of the same underlying security that has different strike price and expiration date.
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We have credit and debit spreads. When an option sold by a trader has higher premium than the option he purchased, it is called credit spreads while the situation where the option a trader purchased has higher premium than the one he sold is called debit spreads. Another term worth noting is the bull and bear spreads. A bull spread is a spread that is created with the aim of making profit from the rise in the price of the underlying financial instrument while a bear spread is created to profit from the fall of underlying financial instrument. When a trader have more options written than purchased, it is known as ratio spread, while if he have more options purchased than written, it is called a backspread.
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Benefits of Using Option Spread Strategy
Creating a spread may cost you more in a brokerage however it enables your overall position to become cheaper than when you perform straight buying. This is especially more important if you do not want to risk too much capital, making your trade cost less and giving you control of managing your money.
Spreads most time, reduces or even eliminate the price volatility that causes option strike price to become inflated or deflated due to high or low demand at that period.
Spreads give you more flexibility when making the choice of expiry date. Due to the fact that you are both selling and buying, you can extend the expiry date of your positions without affecting your trade overall cost.