The $55 Call would be $5 In-The-Money and would have a premium of $6. Closing the position will still give us $5, and still give us a nett gain of $4.25.

Once both Calls are In-The-Money, our profit will always be limited by the difference between the strike prices of the 2 Calls, minus the amount we paid at the start.

As a general rule, once the stock value goes above the lower Call (the $50 Call in this example), we start to earn profit. And when it goes above the higher Call (the $55 Call in this example), we reach our maximum profit.

So why would we want to perform this Spread?

If we had just done a simple Call option, we would have had to spend the $1 required to buy the $50 Call. In this spread trading exercise, we only had to spend $0.75, hence the - limited risk - expression. So you are risking less, but you will also profit less, since any price movement beyond the higher Call will not earn you any more profit. Hence this strategy is suitable for moderately bullish stocks.

HORIZONTAL SPREADS

We now look a Horizontal Spreads. Horizontal Spreads, otherwise known as Time Spreads or Calendar Spreads, are spreads where the strike prices of the 2 options stay the same, but the expiration dates differ.

To recap: Options have a Time Value associated with them. Generally, as time progresses, an option's premium loses value. In addition, the closer you get to expiration date, the faster the value drops.

This spread takes advantage of this premium decay.

Let's look at an example. Let's say we are now in the middle of June. We decide to perform a Horizontal Spread on a stock. For a particular strike price, let's say the August option has a premium of $4, and the September option has a premium of $4.50.

To initiate a Horizontal Spread, we would Sell the nearer option (in this case August), and buy the further option (in this case September). So we earn $4.00 from the sale and spend $4.50 on the purchase, netting us a $0.50 cost.

Let's fast-forward to the middle of August. The August option is fast approaching its expiration date, and the premium has dropped drastically, say down to $1.50. However, the September option still has another month's room, and the premium is still holding steady at $3.00.

At this point, we would close the spread position. We buy back the August option for $1.50, and sell the September option for $3.00. That gives us a profit of $1.50. When we deduct our initial cost of $0.50, we are left with a profit of $1.00.

That is basically how a Horizontal Spread works. The same technique can be used for Puts as well.

For more information on spread trading, visit: http://www.option-trading-guide.com/spreads.html

Steven is the webmaster of http://www.option-trading-guide.com. If you would like to learn more about Option Trading or Technical Analysis, do visit for various strategies and resources to help your stock market investments.

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