Option Spreads: All About Spreads

If individual long and short calls and puts are the building blocks for more sophisticated option trading strategies, then option spreads are what those building blocks add up to.

Option spreads are frequently the mechanism by which risk and time and volatility and value get sorted out and negotiated. Spread can be both generic and highly specific, and just because a trade is classified as one type of spread, it doesn't mean that it can't also be classified as another. Often, there's overlap between option spreads.

Option spreads are essentially offsetting positions, where a long (purchased) position is matched with a short (sold/written) position. Depending upon a variety of different criteria--time, the price of the options involved, the strike price of the underlying security, and even an asymmetrical number of calls and puts--a variety of different risk/reward scenarios will be established.

Here then is a brief summary on one page of common option spreads.

Option Spread Examples and Descriptions

DEBIT SPREAD

Description: Any spread that costs money to set up. The long option portion costs more than the premium received for the short option portion.

Examples: Bull Call Spread, Bear Put Spread, Straddle, Strangle

Purpose: Generally lowers the amount risked in a net long position in exchange for limiting potential profits.

CREDIT SPREAD

Description: Any spread that generates a cash credit when initiated. The premium of the short option portion is greater than the cost to purchase the long option portion.

Examples: Bull Put Spread, Bear Call Spread, Iron Condor

Purpose: Generally reduces total amount of available premium received in exchange for limited hedge protection if the stock's behavior runs contrary to your position or expectations.

VERTICAL SPREAD

Description: Simultaneously buying and selling calls (or puts) at different strike prices but with the same expiration date. A vertical spread may also be either a debit spread or a credit spread.

Examples: CREDIT SPREADS: Bull Put Spread, Bear Call Spread, Iron Condor; DEBIT SPREADS: Bull Call Spread, Bear Put Spread

Purpose: Bet on movement (or lack of movement) of underlying stock by a specific date; vertical spreads attempt to limit potential losses or limit amount risked.

HORIZONTAL SPREAD (CALENDAR SPREAD, TIME SPREAD)

Description: Simultaneously buying and selling calls (or puts) at the same strike price but in different expiration months. The long option portion of the spread will be at an expiration date farther in the future than the short option portion.

Examples: Any option trading strategy that mimics, to an extent, a Covered Call or Covered Put strategy. The longer term long option functions as the long (or shorted) stock position so that the short option can be written to collect premium.

Purpose: Exploits the difference between near-term options where time decay is much greater than that of longer term options.

DIAGONAL SPREAD

Description: Simultaneously buying and selling calls (or puts) at different strike prices AND in different expiration months. This is essentially a combination of the VERTICAL SPREAD and the HORIZONTAL SPREAD.

Examples: Similar to the HORIZONTAL SPREAD example above. Diagonal Bull Call Spread or Diagonal Bear Put Spread--both strategies involve buying a longer term In The Money or Deep In The Money option and selling/writing a near term option Out Of The Money or Far Out Of The Money.

Purpose: Allows greater flexibility than straight HORIZONTAL and VERTICAL SPREADS.

RATIO SPREAD

Description: Asymmetrical spread in which more short options are sold than long option(s) are purchased. The long option(s) and short options are also purchased and written at different strike prices (the short option is (Far) Out Of The Money in relation to the long option which is typically In The Money or At The Money but with the same expiration date. The spread may either be a DEBIT SPREAD or a CREDIT SPREAD. The premium received from the short options offsets the premium paid for the long option(s). This is an advanced and potentially risky option trading strategy--since there are more short positions than long positions, you have a "naked" or uncovered situation that could wreak great havoc on your portfolio and the financial well-being of your children's children's children.

Examples: Call Ratio Spread/Bull Ratio Spread (similar to a Bull Call Spread but with an extra short or written call), Put Ratio Spread/Bear Ratio Spread (similar to a Bear Put Spread but with an extra written put, uncovered in this case).

Purpose: Significantly improves returns over Bull Call Spread or Bear Put Spread as long as the stock closes between the strike prices of the long and short positions. Ideal for small directional moves.

BACK SPREAD

Description: Asymmetrical spread in which there are more long options purchased than short option(s) sold (the short option(s) have more premium and thus finance the purchase of a larger number of long options). This is the mirror opposite of a RATIO SPREAD. The long options and short option(s) are also purchased and written at different strike prices (the long options are Far Out Of The Money in relation to the short option(s)) but with the same expiration date. Can be done for either a CREDIT or a DEBIT.

Examples: Call Back Spread; Put Back Spread

Purpose: Attractive strategy if you expect a big move in one direction but want to protect yourself in case the stock moves in the other direction. If set up as a CREDIT SPREAD, the strategy can only lose money if the stock remains between the two strike prices of the long and short positions.

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