Spread Trading: An Introduction to Trading Options in Nine Simple Steps

CHAPTER 34

Trading in Surround Sound: The Fundamental Spread Trade

“With these two option trades under our belts,”said Nate,“we’re now ready to make a quantum leap in our effectiveness with options.”

“That’s right,” said Aaron. “Remember how we told you earlier that we can actually combine option instruments in one trade?”

“Sure.”

“Well, that’s what we’re prepared to do now. We’re going to combine the covered call and the protective put into one deal. It’s called a collar trade. So now there are three elements: buying the stock, buying a put, and shorting a call: long stock, long put, short call. The long put and the short call are the option instruments we use.” (See Figure 34.1.)

“Look what this does for us,” he continued. “The stock itself helps optimize a bullish trend. We bought it in the first place because we’re expecting the stock to increase in value. The short call brings a credit into our account up front, and the long put then protects us if the stock happens to trend bearish.”

“Now because we’re using two option instruments in this trade,” said Nate, “we distinguish between them in this way: we say that the short call is the primary option instrument in this case, because it’s the one we’re using to make money—because of the credit we receive in selling it. We say that the long put is the limiting instrument in this case because it’s the one we’re using to limit our risk—it’s what offers us protection.”

FIGURE 34.1 The Collar Trade

One of the most effective trades ...