How to Build a Risk-Free Options Trade Using Spreads

What if you could trade options with zero risk and still lock in a profit? Sounds impossible, right? With spreads, it’s closer than you think.

Options spreads are a type of trade where you’re buying and selling multiple options of the same asset, though the strike prices and expiration dates are different. The reason we refer to option spreads as a good way to build “risk-free” options trades is because spreads are great risk-management tools that are effective in reducing risk considerably by forgoing a limited amount of profit potential. Now, we’d like to be clear that no trade is truly “risk-free,” but there are certain spread strategies that can minimize risk to near-zero levels under specific conditions.

This guide will walk you through constructing low-risk or “risk-free” options trades using spreads. We’ll outline some practical examples to give you an idea of these concepts in hypothetical scenarios and setups. We’ll also provide some step-by-step guidance for getting started and pulling off these options correctly and effectively. Our guide is best for any new traders who want to learn about options spreads or intermediate options traders looking to reduce risk.

Understanding Options Spreads

If you’re unfamiliar with options spreads, we’ll be talking about what they are and why they’re a great way to trade options and practice a good risk management plan. Another interesting topic we’ll be discussing here is the idea of “free-risk trading” and why it’s a complete myth. Watch as we set the record straight and also give you a baseline understanding of how options spreads can be used to your advantage.

What Are Options Spreads?

Options spreads are trading strategies where traders buy and sell multiple options on the same asset. The underlying assets, however, come with different strike prices and expiration dates. Options spreads come in a few varieties, including the following:

• Horizontal Spreads: This is where traders are buying long and short options with the same strike price and different expiration dates. Horizontal spreads are sometimes called “calendar spreads.”
• Vertical Spreads: This kind of options spread is where traders buy one option contract and sell another option contract at a higher strike price. Vertical spreads come with limited risk on the downside and with capped upside potential.
• Diagonal Spreads: Trading diagonal spreads involves buying long and short positions on two options of the same type. These options contracts come with different strike prices and expiration dates.

It’s worth noting that trading options spreads are different from standalone options trades. Spreads involve traders simultaneously buying and selling several different options contracts with different strike prices and expiration dates. Trading options spreads help traders to design a great risk profile. Options spreads let traders offset their potential losses with gains from the other leg of the trade.

Trading traditional, standalone options contracts has traders buying and selling only one option contract, but the trader is more vulnerable to underlying asset movements as they can be exposed to either larger gains or losses.

Why Use Spreads for Risk Management?

Options spreads are preferable for traders who highly value risk management and might have a lower appetite for risk in general. We’ll talk about the top benefits of using options spreads and how they differ greatly from trading naked options, which are just about the polar opposite of using credit spreads.

Top Benefits

• Defined Risk: Using options spreads, traders can create a position with a predetermined maximum potential loss. Traders can learn about the exact amount of money they could lose on the trade upfront before they even enter the position. Discovering the defined risk on options spreads is done by choosing strike prices and expiration dates carefully, which cap risk exposure.
• Lower Capital Requirements: Because traders are simultaneously buying and selling options with different strike prices, they’re offsetting a portion of their potential losses. Options spreads have a lower capital requirement due to traders only needing to set aside a smaller amount of margin compared to buying and selling naked options.
• Hedging Potential: Options spreads are a terrific hedging strategy because they allow traders to limit potential losses and still maintain some upside potential. When traders create a risk spread across various price levels, traders can enjoy using a strategy that’s a more conservative hedging approach than buying or selling single options.

Contrast with Naked Options

• You Don’t Own the Underlying Asset: Trading naked options refers to selling options without owning the underlying assets, which exposes traders to unlimited losses (in theory).
• Higher Risk: Naked options carry a more significant amount of risk compared to option spreads. The higher risk is due to the potential for unlimited losses. Along with the higher risk, naked options also come with the potential for higher profit, though it’s not as consistent as options spread in producing steady returns.
• The Way the Strategy is Designed: Naked options involve selling on options without a corresponding purchase, while options spread involve combining multiple options with different strike prices and expiration dates.

The Myth of “Risk-Free” Trading

There aren’t any trades or investments in the US options or stock market that are completely risk-free. When the term “risk-free” gets tossed around in the trading world, it’s referring to minimal or minimal or capped risk, not absolute zero risk. Even trades that seem like they have no downside whatsoever still come with their unique risks.

We want all of our readers to go into options trading (and specifically trading options spreads) with realistic expectations—you’re going to encounter risk with any trade you get into, but there are ways to drive the risk down.

• Risk Management Practices: Remember to use good position sizing for each of your trades, no more than 1-2%. Spread your traders out over multiple industries and sectors for good diversification. Set up stop-loss orders to minimize potential losses.
• Market Efficiency: Markets are notable for becoming more efficient with enough time, and this can reduce the opportunities for mispricing, which leads many traders to losses to begin with.
• Human Behavior: A lot of risk that comes with trades comes from the decisions of the traders themselves. Humans have a tendency to overreact to significant market events, plus there’s the phenomenon of herding and recency bias that can have an effect on markets that create risk for the trader.

Key Spread Strategies for Low-Risk Trading

For any traders who want to construct some low-risk strategies, keep reading to learn the key options spreads that make this happen, like riskless arbitrage spreads, iron condors, and calendar spreads. We’ve outlined these three key techniques below for your convenience, along with how they work, the risks associated with each, and what the best conditions are to use them.

Strategy 1—The Riskless Arbitrage Spread (Box Spread)

A box spread (or the long box strategy) is a combination of a bull call spread and a bear put spread with identical strike prices and expirations. Traders are buying and selling options to profit from price discrepancies—the ultimate goal is to make money from the differences in the price between the options.

How It Works

The trader must buy a bull call spread and a bear put spread with the same expiration date and strike price. The profit or loss is locked in at the time of the trade entry. The locked-in, guaranteed profit is due to pricing inefficiencies, which are rare in efficient markets. Again, the goal with the box spread is to profit from the difference in prices between the two options contracts.

Example

A good example of the box spread in action would involve the trader buying a 100 call, and selling a 110 call. Then they would buy a 110 put and sell a 100 put.

• Profit Calculation: $10 spread + $9.50 cost = $0.50 profit

Risks

• Execution risk with getting the pricing needed for all four legs
• Early assignment can disrupt the strategy on short contracts
• Market efficiency can reduce opportunities
• Options that are mispriced can lead traders to significant losses
• Commissions can eat into your profit margins

When to Use

The box spreads are ideal to use in highly liquid markets with mispriced options. Traders should use this strategy when they think the price of an asset will stay within a certain range until the expiration date. Traders can use the box spread to borrow or lend at a better rate than their broker or bank.

Strategy 2—The Iron Condor

The iron condor is a trading strategy that’s best used in markets where most people have a neutral outlook. The iron condor profits when the underlying asset prices stay within a certain range. It’s the combination of a bull put spread and a bear call spread. The name “iron condor” refers to the shape of the profit/loss graph, which looks like the wing span of a condor. Because the strategy is made by combining both calls and puts, this is why the name of the technique begins with the term “iron.”

How It Works

The iron condor is a popular move for traders who are interested in turning a profit in a market that’s experiencing low volatility and is relatively stable. The iron condor is designed to profit when the underlying asset trades within a particular range (it comes with capped risk). At the time of execution, the maximum profit and loss scenarios of the iron condor are known. Iron condors ultimately benefit from time decay as well as dropoffs in implied volatility.

Example

To give you a clear idea of how iron condors could work, we’ve outlined the following example:

• Sell a 95 put
• Buy a 90 put
• Sell a 105 call
• Buy a 110 call

Let’s say the break-even points of another iron condor are $48 and $62. You have the distance of the break-even points from the short strike which are 62-60 and 50-48. It’s equal to the initial cash flow. The distance from the break-even points on the short strikes from the long strikes equals the maximum loss. The long strikes are 48-45 and 65-62.

Risks

• Complex Technique: This might not be the best technique for traders who have little experience.
• Limited Profit Potential: One of the primary risks of the iron condor is the limited profit potential, which is the net premium received on the trade.
• Market Changes: Iron condors don’t stand up well to sudden, unexpected market movements, but do a lot better when the markets are stable. Sudden market changes can result in some negative outcomes for the trader.
• Costs of the Transaction: Traders using the iron condor can rack up a lot more in transaction costs by buying and selling multiple options to create the trade.
• Unexpected Market Events: Traders will experience considerable losses if there are sudden volatility spikes in the market landscape.
• Margin Requirements: Some traders might have to satisfy margin requirements when executing an iron condor trade. However, this comes down to the broker you’re using.
• Assignment Risk: Traders run the risk of their long and short options expiring or being assigned at the same time.

When to Use

Sideways markets with low volatility are the ideal conditions for an iron condor. It’s a period where the price of an asset doesn’t trend up or down—the price moves within a range between the support and resistance levels. Sideway markets are characterized by no clear direction and many traders are uncertain of where it will go. However, despite the uncertainty, the volatility in a sideways market is lower than usual.

Using the iron condor is best when you’re expecting the stock price to stay within a certain range. It’s also good when traders are expecting a neutral bias market and are expecting implied volatility to go down or stay low.

Strategy 3—The Calendar Spread

Calendar spreads (also known as intra-market spreads, inter-delivery spreads, or horizontal spreads) are a strategy where traders buy and sell options contracts on the same asset with different expiration dates. Selling a near-term option and buying a longer-term option at the same strike. Calendar spreads profit from the passage of time and they are most often used in the futures market where traders can roll positions from one month to another when it comes to delivery.

How It Works

Traders must buy one option contract and sell another contract at the same time (both will be calls or both will be puts). It involves two open positions at the same time, one being a long position and the other being a short one. Leverages time decay while capping downside risk. Traders have the choice of choosing the same strike price for both, or they can choose to have two different strike prices for each contract.

Example

The trader sells a March 100 call and buys a June 100 call. What is happening here is that the trader believes the market will be stable until after June, when it will rally. The trader is taking on a debt position (they’ll pay at the start of the trade), and they aim to minimize the impact of the movements in the underlying security.

Risks

• Sharp Market Movements: Traders can incur net losses when there’s a sharp market movement in either direction.
• Early Expiration Dates: Traders can experience unlimited losses if they don’t replace a short call when it expires.
• Large Price Changes: Long and short options are susceptible to losing value if there happen to be large or sudden price changes in the options market.
• High Volatility: If the market moves sharply against your spread, high volatility can lead to larger losses or more limited profit.
• The Trader Waits Too Long: The stock price movement could move negatively against traders who wait too long to try to rake up additional profit. It’s best not to wait too long before acting.
• Execution Risks: Traders could have a solid plan in place for the positions they choose for their calendar spread, but a misalignment in execution with the two legs of the trader can cause the trade itself to be modified in a way that produces a different outcome.
• Time Decay: A Calendar spread can be complex when it comes to managing time decay effectively. It requires traders to have a deep understanding of how theta decay can impact options prices.

When to Use

In general, calendar spreads are best used when the trader is expecting short-term stability and long-term movement. Traders use this technique to profit from the price difference between the options with different expiration dates, both in the options and futures markets. However, the ideal time to use the calendar spread comes down to the type of calendar spread you’re using.

• Long Call Calendar Spread: Traders are expecting the stock price to drop slightly in the near future or to remain relatively steady.
• Long Put Calendar Spread: Traders are expecting the stock price to rise slightly in the near future or to remain relatively steady.
• Short Calendar Spread: Traders are expecting a big price move in the short-term future.
• Futures Calendar Spread: Traders use this move when dealing with futures contracts, not option contracts. They use this technique when they want to roll over a position for delivery into the next month.

Step-by-Step Guide to Building a Low-Risk Spread Trade

If you’re interested in constructing a trade that’s centered around a low-risk spread, we’ve provided some step-by-step instructions for getting started. Use this guide if you’re having any doubts about how to build options spreads, the tools needed to get the job done, or the specific steps to breaking ground.

Step 1—Define Your Market Outlook

The first step you have to make is to determine how you are currently feeling about the market. If you’re expecting the market to rise, you have a bullish outlook. A bearish outlook is the expectation that the market will decline. A neutral stance takes on neither of these outlooks. Once you’ve figured out how you feel about the market, you’ll need to choose a spread that aligns with your view.

Step 2—Select the Right Spread Strategy

Choose a trading strategy that matches your personal risk tolerance and market conditions. For bullish markets, traders should use call options, bull call spreads, or long calls. Bearish traders should use bear butterfly spreads, synthetic puts, or diversify their holdings. Iron condors are good for a neutral approach.

Step 3—Choose Strike Prices and Expirations

Once you’ve established your risk tolerance, desired profit potential, and market outlook, choose strike prices for your spread that align with your thoughts on where the underlying asset price is going to move. Use option chains to identify optimal strikes. High-risk traders might prefer using further-out-of-the-money options, while more conservative traders will likely prefer near-the-money strikes.

Balance premium cost with risk and reward. The distance between the strike prices impacts the potential profit and loss of the spread. For example, you have wider spreads that offer the trader larger potential gains, but they also come with a much larger premium to purchase.

Step 4—Calculate Risk and Reward

Use a trading platform or calculator to define max profit, max loss, and breakeven points. If you want to calculate the risk reward manually, you would divide your net profit by the price of your maximum risk. To figure out the net cost, subtract the premium received from selling the short leg from the premium paid for the long leg.

Step 5—Execute the Trade

Before placing your order, take the time to consider any order limits that might be in place with your online broker app of choice. It’s also highly advisable to check liquidity before placing an order. Traders can do this by looking at the open interest, volume, and bid-ask spread. The ideal conditions for executing the trade in a liquid market is looking for a narrower spread, greater open interest, and higher volume. This will make it much easier to enter and exit your positions at optimum prices.

Step 6—Monitor and Adjust

Track the price of the underlying asset. While you’re doing this, it’s best to adjust the position as needed. How you adjust the position depends on your current risk tolerance and the market movements you’re seeing. This can inform big decisions such as when to close positions early or roll future positions to the next month for delivery.

Practical Example—Building an Iron Condor

We touched briefly on the iron condor a few sections back, but we’d like to dive into some deeper details on how to build them. Keep reading to learn about a hypothetical iron condor setup that comes with an analysis of the risks and rewards associated with the trade and some outcome scenarios. This section is designed to give you a clear, accurate picture of what could happen when executing an iron condor spread.

Scenario

The hypothetical example is that Stock XYZ is currently trading at $100 and traders are largely expecting it to stay between $95 and $105 for 30 days.

Trade Setup

At the same time, traders must sell a $105 call and buy a $110 call, while also selling a $95 put and buying a $90 put. The expiration date for all positions occurs exactly 30 days after the purchase. The net credit for the iron condor would be $2.00 per contract ($200 total).

Risk/Reward Analysis

The next step is to figure out the ratio of the maximum potential loss to the maximum potential profit. The risk and reward analysis is helpful for traders who want a firm idea of the best and worst-case scenarios in an options spread. For this example, we’ve done the following risk and reward analysis:

• Max profit: $200 (if XYZ stays between $95-$105).
• Max loss: $300 (if XYZ exceeds $110 or falls below $90).
• Breakeven: $93 and $107.

Outcome Scenarios

Now we come to the possible outcomes for this hypothetical options spread scenario:

• Full Profit: XYZ stock is at $100 by the expiration date
• Max Loss: XYZ stock is at $115 by the expiration date

Common Mistakes to Avoid

If you’re new to trading options spreads and you don’t want to make any careless mistakes that could be avoided altogether, keep reading, as we’ll address the most common mistakes to avoid when dealing with options spreads. The key to succeeding with this strategy is to do some good initial research and outline the risk and reward scenarios ahead of time to ensure everything aligns with your current market outlook and risk tolerance.

• Overlooking Commissions and Fees: High transaction costs can erode “risk-free” profits. This can happen more quickly than you would think, with so much buying and selling that goes on when putting together an options spread trade.
• Ignoring Volatility: Misjudging implied volatility can increase risks associated with trading options spreads. Spreads profit the most in a sideways market with low volatility, so trading to execute this kind of trade when implied volatility is high, to begin with, or spikes up unexpectedly, can lead to the entire strategy falling apart.
• Poor Timing: Entering spreads too close to expiration or during earnings events can result in less-than-ideal outcomes for traders. Entering the spreads too close to expiration doesn’t give the trade enough time to turn a profit, while entering during earnings might result in the trader entering the trade at too high of a price, which impacts their profit.
• Neglecting Liquidity: Thinly traded options lead to wider spreads and execution issues. Traders want to look for narrower spreads, greater open interest, and higher volume. Neglecting liquidity can result in traders not being able to enter and exit positions at a fair price.

Tools and Resources for Spread Trading

To trade options spread well, traders need to have the right tools and resources at their disposal. Check out the best in options trading platforms, options calculators, and educational resources that will make your options spread trading experience dynamic and smooth.

Options Calculators

Online is replete with plenty of free and paid options calculators that traders can enjoy to help them model spreads. Traders can determine the value of options and potential profits. Options calculators are designed for all kinds of traders, including the newest newcomers or seasoned traders with plenty of background experience.

• CBOE Options Calculator—This is a free tool that works well for newbies and advanced traders. It includes a trade optimizer and metrics.
• Barchart Options Calculator—A more advanced options calculator, Barchart offers Greeks for US options and uses the Black 76 Pricing model to calculate fair value prices.
• Optionistics—If you’re looking for an options calculator that supports multiple trading strategies outside of simple options spreads, the one offered by Optionistics might be the right choice for you.
• OptionsXpress—Enjoy real-time data to inform your options spreads with this integrated, robust options calculator presented by OptionsXpress.
• Options Profit Calculator—This free tool does a great job of calculating the potential profits of multiple call-and-put option contracts.
• OptionStrat—Save and monitor your trades (including credit spreads) with this options calculator, which also comes with a great optimizer.
• Thinkorswim—Presented by TD Ameritrade, the Thinkorswim options calculator is designed for more advanced options traders. It does a phenomenal job of simulating real-world trades.

Trading Platforms

To successfully trade options spreads, traders will want to use brokerage apps and online options trading platforms with robust options analysis. We’ve included a few examples of the best platforms for getting some of the most advanced analysis of options contracts on the market that are best for options spreads:

Thinkorswim

• Risk Profile: Thinkorswim offers this tool, which visualizes the potential profit or loss of an option spread based on the movement of the underlying price for the selected strategy.
• Probability Analysis: This tool calculates the probability of option contracts reaching certain price levels by the contract’s expiration date.
• “Analyze” Menu Option: Traders can view risk graphs, simulate trades, and access probability calculators under this menu option, where you’ll find the bulk of Thinkorswim’s option analysis tools.
• Options Chain: Traders can get a display of all available options contracts using the options chain, along with pertinent information like the strike prices and expiration dates of the selected underlying securities.
• “ThinkBack:” Traders can backtest options strategies like spreads by using historical data to see how certain traders might have performed in the past. Select “ThinkBack” to access Thinkorswim’s dynamic backtesting tools.

Interactive Brokers

• Option Chains: This tool shows traders all the Greek variables and option prices over time as well as values like option volume, historical volatility, and implied volatility.
• Options Analytics: Traders can use this resource to see how an option’s price changes about Greek value unit changes, plus they can visualize changes in volatility, price effect, and expiration on options’ value.
• Probability Lab: Interactive Brokers offers this tool to trades who want an analysis of the market’s probability distributions.
• Option Market Scanners: This dynamic tool monitors option activity in the wider market.
• Option Strategy Lab: Get an idea of price range estimate using Interactive Brokers’ option strategy hub.
• Performance Profile: This tool lets traders see estimated profit and loss for single-leg combinations or multi-leg combinations.

Educational Resources

One of the keys to getting better with trading options spreads is keeping up with your knowledge of risk management and how market volatility can affect the price of options contracts. We’d encourage you to look into these educational resources at OptionsTrading.org to continue your learning of options spreads for continued success in the future.

• Types of Options Spreads
• Volatility in Options Trading
• Volatility Traps in Options Trading (And How to Avoid Them)
• What Every New Options Trader Gets Wrong About Risk

Minimize Risk with Option Spreads

Using option spreads like box spreads, iron condors, and calendar spreads can minimize risk by letting traders buy and sell options with different strike prices on the same underlying asset. These setups lead traders to develop a defined risk profile where they can limit their exposure to large price changes. The minimization of risk is in the capping of losses to the difference between the strike prices of the options contracts. Traders still maintain the opportunity to profit from different directional market movements.

Before using option spreads, it’s ideal for traders to do good market analysis by using reputable, reliable broker apps and to work out all possible outcomes with option calculators. It’s also advisable to practice paper trading before risking real capital. Explore more OptionsTrading.org – A Complete Guide to Successful Options Trading articles—feel free to leave your comments or questions about your favorite spread strategies!