Options trading spreads

What are Options Spreads?

Options spreads form the basic foundation of many options trading strategies. A spread position is entered by buying and selling an equal number of options of the same class on the same underlying security, commodity, or financial instrument, but with different strike prices, different expiration dates, or both.

The three main classes of spreads are vertical spreads, horizontal spreads, and diagonal spreads. They are grouped by the relationships between the strike price and expiration dates of the options involved.

Vertical spreads, also known as money spreads, are spreads involving options of the same underlying security, commodity, or financial instrument having the same expiration month, but with different strike prices.

Horizontal spreads, also known as calendar spreads, or time spreads are created using options of the same underlying security, commodity, or financial instrument at the same strike prices but with different expiration dates.

Diagonal spreads are created using options of the same underlying security, commodity, or financial instrument having both different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.

Call and Put spreads.

Any spread that is constructed using Calls can be referred to as a Call spread. Any spread that is created using Put options can be referred to as a Put spread.

Bull and Bear spreads.

If a spread is designed to profit from a rise in the price of the underlying security, commodity or financial instrument it is a bull spread. If a spread is designed to profit from a fall in prices of the underlying security, commodity, or financial instrument, it is a bear spread.

Credit and debit spreads.

If the premium of the options sold is higher than the premium of the options purchased, then a net credit is received when entering the spread. If the premium of the options sold is less than the premium of the options purchased, then a net debit is received. Spreads that are entered on a credit are known as credit spreads while those entered on a debit are known as debit spreads.

Ratio spreads and Backspreads.

There are also spreads in which an unequal number of options are simultaneously purchased and written. When more options are written than purchased, it is a ratio spread. When more options are purchased than written, it is a ratio backspread.

Spread combinations.

Many options strategies are built around spreads and combinations of spreads. For example, a bull Put spread is basically a bull spread that is also a credit spread while the Iron Butterfly (see below) can be broken down into a combination of a bull Put spread and a bear Call spread.

Butterfly Spreads.

A Butterfly spread is an option strategy combining a bull and bear spread. It uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both Puts and Calls can be used. This is a strategy having both limited risk and limited profit.

The Iron Butterfly is a neutral strategy similar to the Iron Condor (see below). However, in the Iron Butterfly an investor will combine a Bear-Call credit spread and a Bull-Put credit spread setting the sold Put and the sold Call at the same strike price (At-the-Money). Since the price of the underlying security, commodity, or financial instrument rarely falls at an exact strike price, Iron Butterflies can be traded when the sold Call is slightly In-the-money (ITM) or the sold Put is slightly In-the-Money (ITM).

Once a trader or investor has picked the strike price for the sold options, the trader or investor will look to purchase the same number of Call(s) further Out-of-the-Money (OTM) and the same number of Put(s) Out-of-the-Money (OTM). The sold Call(s) and Put(s) make up the 'Body' of the Iron Butterfly Position and the OTM purchased Call(s) and Put(s) make up the 'Wings' of the position.

Since the investor is selling an ATM Put and an ATM Call, and then purchasing an OTM Put and OTM Call for protection, a net credit is achieved. Because there are two spreads in this position (four options) there is an upper and lower break even point. A profit will be achieved if the stock price is below the upper break even and above the lower break even. The maximum profit for the Iron Butterfly position occurs if the stock price expires right at the sold options strike price. All four options will expire worthless and the investor will keep the entire net credit. The maximum risk is equal to the differences in strike prices between the two Calls or the two Puts (whichever is greater) minus the initial net credit achieved.

Box Spreads.

A box spread consists of a bull Call spread and a bear Put spread. The Calls and Puts have the same expiration date. The resulting portfolio is delta neutral. For example, a 50-60 March box consists of:

Long a March 50-strike Call Short a March 60-strike Call Long a March 60-strike Put Short a March 50-strike Put.

A box spread position has a constant payoff at exercise equal to the difference in strike values. Thus, the 50-60 box example above is worth 10 at exercise. For this reason, a box is sometimes considered a "pure interest rate play" because buying one basically constitutes loaning some money to the counterparty until exercise. In essence a box places the trader long the inside of the box and short the outside of the box. When all sides of the box are in place, it is not possible to experience a loss unless the box is dismantled prior to expiration.

Building a fence by using options is an alternative to consider. A fence is built around the net price needed for a satisfactory result. A minimum price is set under which the price cannot fall and a maximum price is set over which the net price cannot rise. To build a fence a Put option is purchased with a strike price just below the current price of the underlying security, commodity, or financial instrument, and a Call option is sold at a strike price above the current price of the underlying security, commodity, or financial instrument. The Put option establishes a floor price for the underlying. The Call option establishes a ceiling price .

Condor Spreads.

The Condor spread is similar to a butterfly spread. A condor is an options strategy that has a bear and a bull spread, except that the strike prices on the short call and short put are different. The purpose of the Condor spread is to earn limited profits, regardless of market movements, with a small amount of risk. The Iron Condor is an advanced options strategy that involves buying and holding four different options with different strike prices. The iron condor is constructed by holding both a long and short position in two different Strangle strategies. A strangle is created by buying or selling a Call option and a Put option with different strike prices, but the same expiration date. The potential for profit or loss is limited in this strategy because an offsetting strangle is positioned around the two options that make up the Strangle at the middle strike prices.

This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security from which the options are derived. An iron condor is very similar in structure to an iron butterfly, but the two options located in the center of the pattern do not have the same strike prices. Having a Strangle at the two middle strike prices widens the area for profit, but also lowers the profit potential.

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5 basic options strategies explained.

The ability to manage risk vs. reward precisely is one of the reasons traders continue to flock to options. While an understanding of simple calls and puts is enough to get started, adding simple strategies such as spreads, butterflies, condors, straddles and strangles can help you better define risk and even open up trading opportunities you didn’t have access to previously.

Although it may seem daunting at first to put on these strategies, it’s important to remember most are just a combination of calls and puts, says Marty Kearney, senior instructor at CBOE Options Institute. “These names came about so that people who were phoning in orders to trading desks could convey very quickly what they wanted to do. These are all pretty basic strategies, just taking things up a notch.”

A call gives the buyer the right, but not the obligation, to buy the underlying asset at the purchased strike price. A put gives the buyer the right, but not the obligation to sell the underlying asset at the purchased strike price.

An options spread is any combination of multiple positions. This can include buying a call and selling a call, buying a put and selling a put, or buying stock and selling the call (which would be a covered write). For our purposes, we are going to look more closely at a vertical call bull spread, which is used if we expect the price of the underlying stock to rise, although these same principles can be applied to bull put spreads, bear call spreads and bear put spreads.

Fundamentally, vertical spreads are a directional play, says Joseph Burgoyne, director of institutional and retail marketing for the Options Industry Council, which means the investor needs to have an opinion whether the underlying is going to go up or down. Additionally, while they have limited risk, they also have limited reward.

Kearney explains, “What I’m looking at is I want to control the stock, and I think we’re going to a certain dollar amount. I’m willing to give up anything above that,” he says. For our example of a vertical call bull spread, he uses a stock trading at $63 that he believes will go at least to $70.

You simply could buy either the stock or a single call, but by purchasing the bull call spread you are able to better limit your risk. In Kearney’s example, we put on the 60-70 vertical call spread, which consists of buying one in-the-money 60 call and selling one out-of-the-money 70 call. Because we sold the 70 call, we limit the maximum value of our spread to $10 (minus commissions), but we lower our breakeven for the trade because of the credit we earned selling the 70 call. Additionally, our loss is limited to the cost of the spread.

Spread Options and Spread Trading.

Spread option trading is a technique that can be used to profit in bullish, neutral or bearish conditions. It basically functions to limit risk at the cost of limiting profit as well. Spread trading is defined as opening a position by buying and selling the same type of option (ie. Call or Put) at the same time. For example, if you buy a call option for stock XYZ, and sell another call option for XYZ, you are in fact spread trading.

By buying one option and selling another, you limit your risk, since you know the exact difference in either the expiration date or strike price (or both) between the two options. This difference is known as the spread, hence the name of this spread treading technique.

Various strategies can be carried out using this technique. The main ones are vertical spreads, horizontal spreads and diagonal spreads.

A Vertical Spread is a spread option where the 2 options (the one you bought, and the one you sold) have the same expiration date, but differ only in strike price. For example, if you bought a $60 June Call option and sold a $70 June Call option, you have created a Vertical Spread.

Let's take a look at why you would do this. Let's assume we have a stock XYZ that's currently priced at $50. We think the stock will rise. However, we don't think the rise will be substantial, maybe just a movement of $5.

We then initiate a Vertical Spread on this stock. We Buy a $50 Call option, and Sell a $55 Call option. Let's assume that the $50 Call has a premium of $1 (since it's just In-The-Money), and the $55 Call has a premium of $0.25 (since it's $5 Out-Of-The-Money). So we pay $1 for the $50 Call, and earn $0.25 off the $55 Call, giving us a total cost of $0.75.

Two things can happen. The stock can either rise, as predicted, or drop below the current price. Let's look at the 2 scenarios:

Scenario 1 : The price has dropped to $45. We have made a mistake and predicted the wrong price movement. However, since both Calls are Out-Of-The-Money and will expire worthless, we don't have to do anything to Close the Position. Our loss would be the $0.75 we spent on this spread trading exercise.

Scenario 2 : The price has risen to $55. The $50 Call is now $5 In-The-Money and has a premium of $6. The $55 Call is now just In-The-Money and has a premium of $1. We can't just wait till expiration date, because we sold a Call that's not covered by stocks we own (ie. a Naked Call). We therefore need to Close our Position before expiration.

So we need to sell the $50 Call which we bought earlier, and buy back the $55 Call that we sold earlier. So we sell the $50 Call for $6, and buy the $55 Call back for $1. This transaction has earned us $5, resulting in a nett gain of $4.25, taking into account the $0.75 we spent earlier.

What happens if the price of the stock jumps to $60 instead? Here's where the - limited risk / limited profit - expression comes in. At a current price of $60, the $50 Call would be $10 In-The-Money and would have a premium of $11. The $55 Call would be $5 In-The-Money and would have a premium of $6. Closing the position will still give us $5, and still give us a nett gain of $4.25.

In tabular format:

Once both Calls are In-The-Money, our profit will always be limited by the difference between the strike prices of the 2 Calls, minus the amount we paid at the start. As a general rule, once the stock value goes above the lower Call (the $50 Call in this example), we start to earn profit. And when it goes above the higher Call (the $55 Call in this example), we reach our maximum profit.

So why would we want to perform this spread option? If we had just done a simple Call option, we would have had to spend the $1 required to buy the $50 Call. In this spread trading exercise, we only had to spend $0.75, hence the - limited risk - expression. So you are risking less, but you will also profit less, since any price movement beyond the higher Call will not earn you any more profit. Hence this strategy is suitable for moderately bullish stocks.

This particular spread we have just performed is known as a Bull Call Spread , since we performed a Call Spread with a bullish or upward-trending expectation. Similarly, Bull Put Spreads , Bear Call Spreads and Bear Put Spreads are all based on the same technique and function quite the same.

Bull Put Spreads are strategies that are also used in a bullish market. Similar to the Bull Call Spread, Bull Put Spreads will earn you limited profit in an uptrending stock. We implement Bull Put Spreads by buying a Put Option, and by selling another Put Option of a higher strike price. The Bear Spreads are similar to the Bull Spreads but work in the opposite direction. We would buy an option, then sell an option of a lower strike price, since we anticipate the stock price dropping.

We now look a Horizontal Spreads Options . Horizontal Spreads, otherwise known as Time Spreads or Calendar Spreads, are spreads where the strike prices of the 2 options stay the same, but the expiration dates differ. To recap: Options have a Time Value associated with them. Generally, as time progresses, an option's premium loses value. In addition, the closer you get to expiration date, the faster the value drops. This spread takes advantage of this premium decay.

Let's look at an example. Let's say we are now in the middle of June. We decide to perform a Horizontal Spread on a stock. For a particular strike price, let's say the August option has a premium of $4, and the September option has a premium of $4.50. To initiate a Horizontal Spread, we would Sell the nearer option (in this case August), and buy the further option (in this case September). So we earn $4.00 from the sale and spend $4.50 on the purchase, netting us a $0.50 cost.

Let's fast-forward to the middle of August. The August option is fast approaching its expiration date, and the premium has dropped drastically, say down to $1.50. However, the September option still has another month's room, and the premium is still holding steady at $3.00. At this point, we would close the spread position. We buy back the August option for $1.50, and sell the September option for $3.00. That gives us a profit of $1.50. When we deduct our initial cost of $0.50, we are left with a profit of $1.00. That is basically how a Horizontal Spread works. The same technique can be used for Puts as well.

A Diagonal Spread Option is basically a spread where the 2 options differ in both strike price and expiration date. As can be seen, this spread contains a lot of variables. It is too complex and beyond the scope of this guide.

We hope you have enjoyed this guide, and benefited from the simpler terms we've used to describe option trading. Do note that throughout the guide, we have not taken into account additional costs such as commissions and differences in bid/ask prices. Including these would have complicated this guide more than we wanted. Just note that these costs exist and will add to your costs and lower your profits.

If you want to read up on more sophisticated strategies that involve more complex combinations of option purchases and sales, do check out our Advanced Options Strategies Guide . And if you are interested in learning about Technical Analysis and Technical Indicators, do visit our Technical Analysis Guide if you have not already done so.

Other Topics in this Guide.

Other Topics in this Guide.

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Types of Options Spreads.

The real benefits of options trading come with using options spreads. It's perfectly possible to make profits under any market condition by simply using a combination of the straightforward buying and selling of calls and puts, but if you can learn to use options spreads then you will discover many more opportunities to make profits.

An options spread basically consists of taking a position on two or more different options contracts that are based on the same underlying security. For example, if you buy contracts on a particular stock and also write contracts on that same stock, then you have essentially created an options spread.

They are primarily used for two specific reasons, limiting the risk and lowering the upfront costs of taking a particular position. However, there are many, many different types and some of them are very simple while others are more complex. There are also a number of different ways that they can be classified.

In this section we look at the main types, how they work, and how they are created. The following types of are all covered, along with some further information on them in your trading strategy. You should be aware that a number of them can fall into multiple categories.

Call & Put Credit & Debit Vertical, Horizontal & Diagonal Calendar Ratio Options Spreads & Options Trading Strategy.

The simplest way to classify a spread is on what basic type of options are used – calls or puts. Although some spreads can use a combination of both, most of them use either just calls or just puts. Any spread that is made up using only calls is known as a call spread, while one that is made up using only puts is known as a put spread.

Credit & Debit.

Spreads can also easily be classified based on the capital outlay involved. When you create one you will either incur an upfront cost or receive an upfront credit. If you incur an upfront cost by spending more on buying contracts than you receive from writing contracts, then this is known as a debit spread. If you receive an upfront credit by spending less on buying on contracts than you receive from writing contracts, then this is known as a credit spread.

Vertical, Horizontal & Diagonal.

Another method for classifying spreads is based on the positions of the options relative to each other on an options chain. Spreads that involve buying and writing contracts of the same type, same expiration date, and the same underlying security but with different strike prices would appear vertically stacked on an option chain and as such are known as vertical spreads.

Those that involve buying and writing contracts with different expiration dates, but the same type, same strike price, and same underlying security are known as horizontal spreads. Buying and selling options that have different strike prices and different expiration dates, but are the same type and same underlying security, is creating a diagonal spread.

These involve options that have different expiration dates. Horizontal spreads and diagonal spreads are both examples of calendar spreads, but there are other types too. They are essentially used to try and profit from differing rates of time decay between the contracts written and the contracts bought.

This is applied to any spread that involves buying and selling differing amounts of options contracts, as opposed to buying an amount of contracts equal to the amount written. Typically they involve writing more contracts than are being bought, but the ratio can work either way around depending on what strategy is being used.

Options Spreads & Options Trading Strategy.

The different types of spread is a very important subject in options trading, as most strategies involve using them. There are many different types, and they are not all covered in this particular section. Instead, we have just covered the main categories, explaining their basic characteristics, and showing you how they can be used.

We would suggest familiarizing yourself with the information in this section first, but for a more comprehensive list of the different types you can read our section on options trading strategies. In that section we cover all the spreads you need to know with detailed information on how to use them.