by Steven Quirk 05/14/08
Q: I like the idea of options spreads to minimize my risk, but how do I know which to use when I'm bearish on a stock or bullish on it?
A: There are numerous option spread strategies, which involve the buying and selling of two or more options in a simultaneous transaction, but two of the most basic are bear-put spreads and bull-call spreads.
As the name would imply, a bear-put spread should be used when you are mildly bearish on a stock, index or sector and expecting it to drop during the life of your option trade. To carry it out, you simply buy one put option and sell another put option against it with the same underlying security at a lower exercise price.
When you are moderately bullish on a particular name, a bull-call spread can reap profits while reducing risk. To complete a bull-call spread, buy one call option with a lower strike price and sell another call option in the same expiration month with a higher strike price against it.
With both trades, you will incur a net debit -- that is, you will pay to purchase the long option, and collect a credit on the option you sell to open. This helps you to reduce the cost of the more-expensive long option, and the less money you have on the table, the lower your risk to enter the trade!
