Derivatives - Spread Option Strategies

The put and call are the building blocks of option strategy. As speculative and risky as they might seem - and some investors do nothing but speculate in them all day long - options were originally intended to reduce risk in an overall portfolio. If you have a large exposure to a company's share price, it is nice to have a put as insurance in case the stock craters.

Calls and puts used in tandem, though, create new ways to hedge a position:

Spreads
A spread is a position consisting of the purchase of an option and the sale of another option on the same underlying security with a different strike price or expiration date.

This is often done in lieu of covering a call. As discussed earlier, covering mitigates a lot of the risk of writing a call - risk which is otherwise unlimited. But covering does tie up a lot of capital that could be productive in some other way. A spread has the same risk-reducing effect as covering, but it is more cost-effective.

There are three kinds of spreads you need to know:

  1. Bull spread
  2. Bear spread
  3. Time spread

Bull and bear spreads are known collectively as "money spreads".

  • Bull Spreads are strategies designed to profit if the price of the underlying stock goes up. It is a two-step process:
    1. Buy an in-the-money call - that is, a call in which the strike price is lower than the stock's spot price.
    2. Sell an out-of-the-money call - that is, a call in which the strike price is higher than the stock's spot price.

This is a complicated strategy, so let's work with the simple example from the call and put diagrams. You start by buying an in-the-money call: 1 MNO May 95 call @ 4, assuming the spot price is now $98. Then you sell an out-of-the-money call: say 1 MNO May 100 call @ 2:


Figure 8.5: Bull Spread


It may not be immediately obvious from this chart, but the investor benefits from a higher share price and has some exposure - but less exposure - to a drop in share price. At least the diagram illustrates why it is called a "spread". Adding up the data from the long call and the data from the short call should clarify the situation:


Figure 8.6: Bull Spread


Clearly, there is a limited upside to this strategy as compared to the long call alone, but the bull spread allows you a broader range of values at which you will realize a profit, your risk of loss is minimized, and selling the short call greatly reduces your net costs.

  • Bear Spreads are strategies designed to profit if the price of the underlying stock goes down. It is mechanically similar to a bull spread, except the investor goes long on the out-of-the-money position and short on the in-the-money position, which is the exact opposite of the bull spread. These are the two steps to follow:
    1. Buy an out-of-the-money call.
    2. Sell an in-the-money call.

Look Out!
Here is an interesting conceptual point to remember: anything you can do with a call, you can do with a put. You can create a bear spread just as well by selling an out-of-the-money put and buying an in-the-money put. You can create a bull spread by selling an in-the-money put and buying an out-of-the-money put.


  • Time spreads
, sometimes called calendar or horizontal spreads, are positions consisting of the simultaneous purchase of one option and sale of another option with a different expiration date on the same underlying security.

  • This allows you either to create a hedge position or to speculate on the rate at which the market price of the options will decline as they approach the expiration date.
Straddle Option Strategies


Related Articles
  1. Investing Basics

    What is a Bull Call Spread?

    A bull call spread is an option strategy that involves the purchase of a call option, and the simultaneous sale of another option (on the same underlying asset) with the same expiration date ...
  2. Options & Futures

    Get Familiar with These 6 Option Strategies

    When you’re ready to move beyond the basics of investing, it’s time to learn your options.
  3. Options & Futures

    Which Vertical Option Spread Should You Use?

    Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
  4. Options & Futures

    Vertical Bull and Bear Credit Spreads

    This trading strategy is an excellent limited-risk strategy that can be used with equity as well as commodity and futures options.
  5. Options & Futures

    What is a Bear Call Spread?

    A bear call spread is an option strategy that involves the sale of a call option, and the simultaneous purchase of a call option (on the same underlying asset) with the same expiration date but ...
  6. Options & Futures

    What Is A Bull Put Spread?

    Investopedia explains: A bull put spread is a variation of the popular put writing strategy, in which an options investor writes a put on a stock to collect premium income and perhaps buy the ...
  7. Active Trading

    How To Manage A Bull Call Spread

    A bull call spread, also called a vertical spread, involves buying a call option at a specific strike price and simultaneously selling another call option at a higher strike price.
  8. Options & Futures

    Understanding Bull Spread Option Strategies

    Bull spread option strategies, such as a bull call spread strategy, are hedging strategies for traders to take a bullish view while reducing risk.
  9. Options & Futures

    Debit Spreads: A Portfolio Loss Protection Plan

    There are ways to control risks, reduce losses and increase the likelihood of success in your portfolio. Find out how spreads can help.
  10. Options & Futures

    The Dangerous Lure Of Cheap Out-Of-The-Money Options

    Betting on an expected move is fine, but one must understand the risks involved in a position - and consider the alternatives.
RELATED TERMS
  1. Buy A Spread

    Option strategy that will be profitable if the underlying security ...
  2. Long Leg

    The part of an option spread strategy that involves buying an ...
  3. Bull Call Spread

    An options strategy that involves purchasing call options at ...
  4. Short Leg

    Any contract in an option spread in which an individual holds ...
  5. Spread

    1. The difference between the bid and the ask price of a security ...
  6. Diagonal Spread

    An options strategy established by simultaneously entering into ...
RELATED FAQS
  1. How do I set a strike price in an options spread?

    Find out more about option spread strategies, and how to set the strike prices for bull call spreads and bull put spreads ... Read Answer >>
  2. How can I use an out-of-the-money put time spread for downside risk?

    Learn how using an out-of-the-money time put spread can be used to hedge downside risk by reducing the amount of premium ... Read Answer >>
  3. What's the difference between a credit spread and a debt spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
  4. What is spread hedging?

    Learn about one of the most common risk-management strategies options traders use, called spread hedging, to limit exposure ... Read Answer >>
  5. How do traders use debit spreads to protect against loss?

    Review an example of how a trader might use a debit spread to limit the maximum loss on an options transaction, limiting ... Read Answer >>
  6. What options strategies are best for investing in the industrial sector?

    Learn a couple of popular options trading strategies that can be used by investors seeking to enhance their profits from ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center