What Is an Alligator Spread?
An alligator spread is a trading position that is bound to be unprofitable from the very outset due to the onerous fees and transaction costs associated with it. The term is in many cases utilized corresponding to the options market, where investors some of the time join different put and call options to form convoluted positions. Each leg of the spread might accompany its own set of trading costs.
Assuming the fees from these transactions become too large, the investor could lose money on the transaction, even on the off chance that the market moves in a generally profitable bearing. In such cases, the potential profits are "eaten" by fees, similar to an alligator.
Understanding Alligator Spreads
Investors as a rule utilize the term "alligator spread" while alluding to trades made in the options market, particularly corresponding to convoluted positions including put and call options. These types of trades are intended to profit from the movement of a underlying asset inside a specific reach.
For example, an investor could profit on the off chance that a stock appreciates or devalues by up to 20% in one or the other heading. In that scenario, the investor faces a somewhat narrow window inside which to profit on the position; assuming that the different fees associated with that position are too exorbitant, it could be unimaginable for them to understand a profit on an after-fees basis, even on the off chance that the security moves in a great heading.
In theory, investors can stay away from this problem via carefully auditing the fees associated with the investment position they are thinking about. Notwithstanding, this can be challenging to do in practice, as there can be various sorts of fees included. These incorporate brokers' commissions, exchange fees, clearing fees, margin interest, and fees associated with exercising options. Different issues, like tax suggestions and bid-ask spreads, can likewise eat into profits. Taking into account that investors in these markets are now dealing in genuinely muddled transactions, it is reasonable that they could fail to understand that they have made an alligator spread — until it is too late.
Despite the fact that competition has would in general lower commissions and different fees after some time, investors ought to in any case carefully survey their brokers' fee timetables to try not to have their profits eaten up by an alligator spread.
Illustration of an Alligator Spread
Charlie is an options trader who is thinking about opening a position with shares in XYZ Corporation as the underlying asset. As of now, XYZ is trading at $20 per share, yet Charlie anticipates that the shares should experience greater volatility throughout the next six months. Specifically, he thinks there is a decent chance that XYZ shares will either rise to $30 or decline to $10 throughout that time period.
To profit from this anticipated volatility, Charlie purchases a call option that terminates in six months and has a strike price of $25. To get this option, he pays a $2 premium.
Albeit this call option permits him to profit assuming XYZ's share price builds, Charlie needs to position himself so he profits on increased volatility whether or not the price goes up or down. With that in mind, he purchases a subsequent choice, this one a put option which terminates in six months and has a strike price of $15 per share. To acquire it, he pays another $2 premium.
Seeing his position, Charlie feels he has achieved his goal. On the off chance that the price climbs to $30, he can exercise his call option and net a profit of $5 per share (buying for the exercise price of $25, and afterward selling for the market price of $30). Since every option addresses a ton size of 100 shares, that works out to a $500 profit. On the off chance that then again prices decline to $10, he can exercise his put option and furthermore net a $5 per share profit (buying for the market price of $10, and afterward selling at the exercise price of $15).
Despite the fact that Charlie's position looks sound on paper, it has one urgent flaw. Charlie failed to keep track of his transaction fees. In the wake of accounting for his premium payments, his representative's commissions, his tax liability, and different costs, Charlie finds that these expenses will total more than $5 per share. Charlie, at the end of the day, has coincidentally found an alligator spread — because of the high costs of his position, he can't bring in money even assuming he is right in his prediction about XYZ.
- Albeit corrupt brokers could in some cases sell investors on alligator spread positions, these circumstances most usually arise by accident.
- An alligator spread is a trading strategy where any opportunity for profit has been deleted by fees and trading costs.
- The term is much of the time utilized in options trading, where multi-leg spreads and other complex trading strategies can include high costs to put on and remove the position.
- To keep away from them, investors must carefully survey every one of the fees associated with their positions, incorporating the costs associated with leaving a position.