Call front spread
The front spread call strategy allows you to purchase a call that is already in the money, or slightly below the point where it would be on the money, at a discounted price. The end goal is to then gain control of the call at the initial strike price for either a small debit or even a credit through the selling of 2 calls at the second strike price. Both strike prices will need to utilize the same expiration month in order for this strategy to be effective.
When utilizing this strategy, you are going to need to be aware that it has an extremely large risk ceiling. This means you are going to need to use traditional indicators in order to determine if the time is right for this strategy in order to prevent yourself from taking a loss when the underlying asset moves more than you expect it to. This strategy is best used if you are slightly bullish about the underlying asset and you believe it will move to the second strike price and then completely stop. If the strength of the market is in question, utilizing a different strategy is recommended.
In order to achieve maximum results with this strategy, you are going to need the underlying asset price to rise from the first strike price to the second. This, in turn, provides cover for one of the calls you purchase while also leaving the second one open to the potential of even greater profits moving forward. This second call will also leave you open to additional risk if the market turns against you unexpectedly. This means you are going to want to keep a close eye on the movement of the underlying asset to ensure quick movements are countered. You will also want to include a strong stop loss situated just below the second strike point to prevent yourself from losing everything.
You can further mitigate the potential for risk through the use of index options rather than standard options. Index options are always a great choice when it comes to utilizing riskier strategies because they are the least volatile type of option you can purchase. This is due to the fact that the movement of various options in the index typically tends to cancel one another out.
To utilize this strategy, the first thing you will need to do is to purchase a call at the initial strike price. You will then want to follow this purchase up with the sale of a pair of calls that are listed at the secondary strike price. The price of the underlying stock should then ideally move enough that you make a profit from the first option while still being able to sell off the pair of calls to fund most if not all of the purchase.
When utilizing this strategy, you are going to want to keep in mind that that the closer the first call is to the expiration date, the greater your potential for profit is going to be. As such, the timeframe that is typically considered the most effective for this strategy is between 30 and 45 days. You can also utilize this strategy through the purchase of the underlying asset directly as opposed to utilizing uncovered calls which mitigate the potential risk somewhat.
Keep in mind that time decay is working in your favor through the use of this strategy. While it will still reduce the value of the option you plan on purchasing, this loss will ultimately be outweighed by the gain that will come with the pair of options you are going to sell.
Put front spread
The put front spread strategy is best used for the purchase of a put that is just at the money or slightly out of the money while not paying full price in the process. When everything works according to plan, you will be able to purchase the put at the second strike price while still earning credit or just a small debit. This extra profit comes from selling two additional puts at the first strike price.
In order for this strategy to be as effective as possible, you will need the price of the underlying asset to decrease from where it starts at the second strike price all the way to the initial strike price. This means you are going to want to utilize this strategy only when the market is feeling bearish. Additionally, you are only going to want to undertake this strategy when the indicators you favor say that the underlying asset is going to drop in price, but only a small amount. This is extremely important if you are going to come out on top as only one of your puts is covered. As such, if the stock moves dramatically you can potentially see significant losses.
This means it is very important to closely monitor the underlying asset when you utilize this strategy and never do so without having a firm stop loss in place to counter potential losses. Much like the call variation, the optimal time frame for this strategy is between 30 and 45 days from when the option will expire.
In order to utilize this strategy, you are going to want to begin by selling a pair of puts at the initial strike price. Next, you purchase a put at the secondary strike price assuming the price of the underlying asset is going to remain at or above this price.
When using this strategy, you are going to want to try and get the price of the underlying asset to end up as close to the first strike price as possible at the moment the option expires. This will ensure that you make the maximum amount of each trade. The amount of profit that you can make on the trade will be determined by the differences between the two strike prices after any net debits are taken into account. On the other hand, the maximum amount of possible loss can be determined by adding the strike prices together. If the underlying asset drops all the way down, this is what you can expect to lose.
When using this strategy, your goal should be for the implied volatility to decrease as time goes on. Doing so will decrease the value of the options you sold at twice the rate of the options you purchased, netting an overall profit.