Using a Call Spread to Fine-Tune Risk / Reward

By Brad Tompkins Sep 28, 2012 11:55 am

Here, how to use an option spread as a way to best exploit the middle ground of moderate price move forecasts.

Today we will dig into using option spreads as a way to best exploit the middle ground of moderate price move forecasts.

There are a great many types of option spread trade strategies. All spreads involve buying a number of option contracts and then offsetting those by selling other option contracts. Just for fun, let’s list the spread categories to give you an idea of the extreme variety of choices:

Bullish, bearish or neutral spreads to match speculative direction expectations.
Credit or debit spreads depending if you desire collecting more option premium than paying.
Call spreads or put spreads and even combinations of both.
Vertical spreads → same expiration period but different strike prices.
Horizontal (calendar) spreads → same strike price but different expiration periods.
Diagonal spreads → different strike price and expiration (vertical and calendar combined).

Is your head spinning yet? And we didn’t even mention condors, butterflies, and ratios. No matter. For the most part, if you can understand one of the more straightforward option spread constructions, all the rest are variations on the common theme. We don’t have to make the concept more difficult than it is.

Trade Setup: A Moderately Bullish Forecast for IWM

If I bring up the Russell 2000 Small Cap ETF (NYSEARCA:IWM), I can simply extend the trend since June using a regression tool and come up with a reasonable price forecast for where price may be in the next month – see chart below. (Please perform more rigorous technical analysis when you are studying trade setups on your own!)