Analysis of Spread Strategies in Derivative Market

Running head: ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
Analysis of Spread Strategies in Derivative Market
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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
1. Introduction:
Spread strategies are the basic theme for trading in option market. In option-spread
strategy, one can enter into two or more contracts of buying and selling the option contract to
mitigate the risk involved in option market. Spread strategy generally provides certainty of
risk associated in option contracts with estimated range of loss or profit to be achieved. The
main motive behind spread strategy to hedge against loss from unpredictable fluctuation in
the price of the underlying assets. A speculator will always try to earn profit from the
difference between price movements of two option contracts of same underlying asset. In
option-spread strategies, directional trade strategy is followed to achieve statistically higher
return for same risk level.1
There are two types of spread strategy:
1. Vertical spread strategy.
2. Horizontal spread strategy.
However, there is one more strategy, which is the combination of Vertical spread
strategy, and Horizontal spread strategy i.e. Diagonal spread strategy. Whatever strategy an
investor is adopting, should be adopted by the deep study of the Gamma, Vega and Theta of
the underlying asset to understand the inherent risk and to determine the intrinsic value of the
underlying stock2.
2. Horizontal Spread strategy:
1 Hull, John. Options, futures and other derivatives/John C. Hull. Upper Saddle River, NJ: Prentice Hall,, 2009.
2 Chance, Don M., and Roberts Brooks. Introduction to derivatives and risk management. Cengage Learning,
2013.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
In a Horizontal spread strategy, the investor used to buy and sell options at the same
strike price with different expiration dates. The main motive behind this strategy is to protect
from unwanted volatility in the price of the underlying asset. This strategy can be applied in
both call and put option depending upon the price volatility belief of the person. This strategy
enjoys time decay benefit of option contract where investor has belief that volatility of the
price of the underlying asset will be affected by the theory of time value of money. The return
in the horizontal spread mostly depends upon the time decay and volatility level of the stock.
The volatility of the stock means statistics of the changes in the price of the underlying asset
in a time horizon. This strategy generally result in limited loss or profit due to selling and
buying option at different exercise prices at different point of time by securing the gap
between both exercise prices as insurance against the loss. The whole strategy can be
explained through the example given below.
Suppose, in the month of June, an investor has purchased call option with a strike
price of $ 250 with expiration date of August end by paying premium of $ 40 and sold call
option ending in the October with premium inflow of $20 at exercise price of $ 280. So, the
investor has limited loss of $ 20 whether the price has gone above $280 or remained below
$250. Let’s explain it through different prices on the exercise date.3
Particulars Price at the expiration date
Strategies 250 $ 280 $ 300 $ 320 $ 340 $ 360
c+ at E= $250 $ - $ 30 $ 50 $ 70 $ 90 $ 110
C- at E= $280 $ - $ - $ (20) $ (40) $ (60) $ (80)
$ - $ 30 $ 30 $ 30 $ 30 $ 30
Less: Net premium outflow. 20 $ 20 $ 20 $ 20 $ 20 $ 20
Profit $ (20) $ 10 $ 10 $ 10 $ 10 $ 10
3 McKeon, Ryan. "Option spread trades: Returns on directional and volatility trades." Journal of Asset
Management 17.6 (2016): 422-433.