Option Spread Trading 101

Trading option spreads is a way to make money within a wide range of market movement, because option values decay as time passes. This referred to as theta decay, or time decay. 

This is why you SELL options instead of buying them. In the case of a spread, you actually buy and sell in combination, with the idea that both will decay. We’ll get into how this is done.

The idea is to execute a trade that will make money from time decay as time passes within a range of price movement.

If you’ve never traded option spreads before it can be confusing, but just like anything else, until you learn it, it may not make a lot of sense.

What is an option?

I think of options simply as decaying instruments listed in the “option chain” on most platforms which can be bought and sold to construct a favorable trade. There are other aspects and nuances of options, but we won't get any more detailed than that for our purposes on this page. You may want to read more on definition of an option on this site or in the many available resources online. 

Example of an option spread - Iron Condor

So, with the S&P 500 index – called SPX - trading at around 3050 at this writing, how would a non-directional option spread be constructed?

One way to do this is with a trade called an Iron Condor. We seldom, if ever, trade iron condors in practice because there are better setups available, but it is a good way to understand the concept.

This is what an iron condor looks like on a graph. It will make money to a max of $700 as long as SPX stays between 2700 and about 3300 until July 17 expiration, a 500 point range. 

option spreads

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Now, take a minute to notice what happens to the profit/loss when the date in the software is advanced to June 30. This is how theta decay works, and how as time passes the position can become profitable.

The lower pink line is the position's current profit/loss. This line moves up over time to meet the light blue line, which is max profit.

(If the image does not enlarge, right click and select "Open image in new tab" or similar.)

option spreads

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And again, when the date is advanced to July 7: (If the image does not enlarge, right click and select "Open image in new tab" or similar.)

option spreads

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To get a better feel for how this works, open a free account (which I don't believe you need to fund) and download the Thinkorswim desktop app here:

https://www.tdameritrade.com/tools-and-platforms/thinkorswim/desktop/download.page

Once you find your way around in the software it is easy to set up the above trade. Go to Add Simulated trades and in the option chain go to July 17 expiration, > Sell > Iron Condor. This is what it looks like:  (If the image does not enlarge, right click and select "Open image in new tab" or similar.)

option spreads

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You'll get something like this, where you can play with the strike prices until the trade is duplicated:  (If the image does not enlarge, right click and select "Open image in new tab" or similar.)

option spreads

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