Alligator spread

What Is Alligator Spread?

An alligator spread is a colloquial term in options trading that describes a situation where the transaction costs and fees associated with a trade consume any potential profits, much like an alligator's jaws devouring its prey. Within the broader realm of options trading, this scenario highlights the critical impact that seemingly small expenses can have on overall profitability. The term specifically applies to strategies, particularly complex multi-leg strategies, where multiple transactions amplify the effect of commissions and other trading expenses. An alligator spread is not a specific trading strategy itself, but rather a cautionary outcome that traders aim to avoid by carefully calculating costs before entering a position.¹⁷

History and Origin

The concept of an alligator spread emerged as financial markets, particularly those for derivatives, became more sophisticated and accessible. Options contracts, giving the holder the right but not the obligation to buy or sell an underlying asset at a predetermined strike price by a certain expiration date, have a long history, with basic forms existing in ancient times. However, organized exchange trading of options began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This development, alongside the later introduction of standardized pricing models, helped democratize options trading, but also brought into sharper focus the cumulative effect of trading costs.¹⁶ In the early days, high fixed commissions per contract meant that strategies involving many individual option legs could quickly become unprofitable due to these accumulated expenses. As market makers facilitated trading, the spread between their buy and sell prices also contributed to these implicit costs.¹⁵

Key Takeaways

• An alligator spread occurs when trading costs, such as commissions, fees, and the bid-ask spread, eliminate or significantly erode potential profits from an options trade.
• It is a cautionary term, not a specific options strategy, and is particularly relevant for complex multi-leg options positions.¹⁴
• While commission structures have evolved, other implicit costs like the bid-ask spread and regulatory fees remain significant considerations for traders.¹³
• Careful calculation of all expenses before executing a trade is essential to prevent an alligator spread from consuming expected returns.

Interpreting the Alligator Spread

Interpreting the alligator spread means understanding that a trade, even one that appears fundamentally sound, can be rendered unprofitable solely due to the accumulation of trading expenses. It highlights the importance of analyzing not just the potential gross profit of an options trading strategy, but also the net profit after all costs are factored in. This is particularly crucial for strategies that involve frequent buying and selling of multiple contracts or those with wide bid-ask spreads. A narrow bid-ask spread generally indicates higher liquidity and lower implicit costs for traders. If the expected profit is less than or equal to the total cost, the trade is essentially an alligator spread, designed to "eat alive" any potential gains.¹²

Hypothetical Example

Consider an investor who believes Stock XYZ, currently trading at $100, will remain stable within a narrow range. They decide to implement a complex iron condor strategy, which involves four different option contracts:

• Buying a 95 put option
• Selling a 97 put option
• Selling a 103 call option
• Buying a 105 call option

Each of these four "legs" incurs a $1.00 commission per contract. Additionally, assume there's an average $0.05 per-share effect from the bid-ask spread on each leg. Since one options contract typically represents 100 shares of the underlying asset, the per-contract cost from the bid-ask spread is (0.05 \times 100 = $5.00).

Total explicit commission cost: (4 \text{ legs} \times $1.00/\text{leg} = $4.00)
Total implicit bid-ask spread cost: (4 \text{ legs} \times $5.00/\text{leg} = $20.00)
Total trading costs for this single iron condor: ( $4.00 + $20.00 = $24.00 )

If the maximum theoretical profit for this iron condor strategy is $20.00 per contract (after accounting for the net premiums received), the trade is immediately an alligator spread. The $24.00 in costs exceeds the maximum potential profit, ensuring a net loss from the outset.

Practical Applications

The concept of an alligator spread serves as a critical consideration across various aspects of financial markets, particularly in options trading. It underscores the importance of a robust risk management framework. Traders and investors must meticulously account for all expenses, both explicit (like brokerage commissions and regulatory fees) and implicit (like the bid-ask spread), before executing trades. This is especially true for strategies involving multiple legs or lower-priced options, where the percentage impact of costs can be disproportionately high.¹⁰, ¹¹

In the real world, avoiding an alligator spread means assessing whether the potential profit margin of a trade outweighs the cumulative cost of entry and exit. Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) emphasize the need for investors to understand the complexities and risks associated with options strategies, implicitly covering the impact of costs.⁹ For example, an investor might consider the liquidity of the options contracts on the chosen underlying asset to gauge the potential impact of the bid-ask spread. More liquid options generally have tighter spreads, reducing this implicit cost. The U.S. Securities and Exchange Commission (SEC) also provides educational resources to help investors understand basic options terminology and the associated risks before engaging in options trading.⁸

Limitations and Criticisms

While the term alligator spread effectively highlights the risk of trading costs eroding profits, it's important to recognize its limitations. The primary criticism isn't of the concept itself, but rather how it might be perceived in an evolving market. The impact of the alligator spread has diminished somewhat with the advent of commission-free trading platforms for many options contracts. However, "commission-free" does not mean "cost-free." Traders still incur other expenses, such as exchange fees, regulatory fees, exercise and assignment fees, and importantly, the bid-ask spread.⁷

Academic research consistently points to transaction costs as a significant factor in the profitability of options strategies. One study notes that "none of the strategy returns survive transaction costs" under certain assumptions, highlighting that even profitable gross returns can be wiped out by trading expenses.⁶ Furthermore, the profitability of short-term, high-frequency options trading can be severely impacted by these costs, leading to lower chances of success over many trades.⁵ Investors focused on very short-term moves or highly volatile instruments need to be particularly aware, as both the bid-ask spread and the rapid decay of time value can quickly consume small gains.

Alligator Spread vs. Bid-Ask Spread

The terms "alligator spread" and "bid-ask spread" are related but refer to different aspects of trading costs. The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask) for a security at a given time. It represents an immediate, implicit cost incurred when a trade is executed, as buyers typically pay the ask price and sellers receive the bid price.⁴

In contrast, an alligator spread is a broader, metaphorical term for a situation where all cumulative trading costs—including not only the bid-ask spread but also commissions, exchange fees, and other miscellaneous charges—eat up all or most of a trade's potential gross profit. While a wide bid-ask spread can be a significant component of an alligator spread, it is just one piece of the puzzle. The alligator spread encompasses the total erosion of profit due to all transactional friction, making a trade unprofitable from the outset.

FAQs

What causes an alligator spread?

An alligator spread is caused by the accumulation of various trading expenses that collectively exceed the potential profit of a trade. These expenses include brokerage commissions per contract or leg, exchange fees, regulatory fees, and the bid-ask spread—the difference between the buy and sell prices. It is particularly common in complex multi-leg strategies where multiple transactions amplify these costs.

³How can traders avoid an alligator spread?

To avoid an alligator spread, traders must meticulously calculate all anticipated transaction costs before entering a trade. This involves factoring in all fees associated with both opening and closing the position, as well as the potential impact of the bid-ask spread. Choosing highly liquid options with tighter bid-ask spreads and minimizing the number of legs in a strategy can help. Some traders also consider using commission-free platforms, though other fees still apply.

Is an alligator spread a trading strategy?

No, an alligator spread is not a trading strategy. It is a descriptive term for a negative outcome where trading costs consume all potential profits from a position. It serves as a warning or a cautionary scenario for traders to consider the full impact of expenses on their profitability.

²Does commission-free options trading eliminate the risk of an alligator spread?

While commission-free options trading significantly reduces one major component of trading costs, it does not entirely eliminate the risk of an alligator spread. Other implicit costs, such as the bid-ask spread, exchange fees, and regulatory fees, can still accumulate, especially with multi-leg strategies or frequent trading, potentially eating into profits.¹