Income strategy – option Spread

Using an option spread involves combining two different option. There are various kind of spread:
-Vertical spread, buy and sell option with different strike price, same expiration date
-Horizontal spread, buy and sell option with same strike price, but different expiration date
-Diagonal spread, buy and sell option with different strike price, and different expiration date
With vertical spread, you can buy Out of The Money (OTM) call, sell further OTM call (bull call spread) or buy OTM put, sell further OTM put (bear put spread). With bull call spread, you counter the long call by the short option reward. This will bring down you cost on the trade than only buying the call option. Futher OTM call is cheaper than OTM call.
For example, ABC is trading at $26.5 on February 20, 2008. Buy the January 2009 $27.00 strike call for $1.40, and sell then January 2009 further OTM at $32.5 strike call for $0.25.
-You only need to pay $1.15, because you receive $0.25 from selling the option, to buy the $1.40 option. ($1.40-$0.25 = $1.15)
-When the stock fall, your maximum loss is the premium you paid for the position that is $1.15
-You get your maximum reward when the stock reaches the further OTM strike price, which is $32.5, because you need to exercise the option you sell. So maximum profit is the difference of strike price – premium paid = $5 – $1.15 = $3.85.
-You will reach your breakeven, at lower strike price + premium paid = $27.5 + $1.15 = $28.65

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