1. Option Spreads: Introduction
  2. Option Spreads: Selling And Buying To Form A Spread
  3. Option Spreads: Vertical Spreads
  4. Option Spreads: Debit Spreads Structure
  5. Option Spreads: Credit Spreads Structure
  6. Option Spreads: Horizontal Spreads
  7. Option Spreads: Diagonal Spreads
  8. Option Spreads: Tips And Things To Consider
  9. Options Spreads: Conclusion

By John Summa, CTA, PhD, Founder of OptionsNerd.com

Now that you have a basic idea of what an option spread looks and feels like (of course limited to our simple vertical bull call spread), let's expand on this foundation to other types of spreads and take a look at another example of a vertical spread. For this example, we will make time a friend to the spreader.

The example from the previous chapter used IBM call strikes of October 85 and 90 to illustrate a simple vertical call debit spread. Recall that vertical means using the same month for constructing the spread. If we were to reverse this type of spread, we would invert the profit/loss dynamics, and it would lead to a credit in your trading account upon opening the position. The objective of the credit spreader - and the parameters of the potential profitability of a credit spread - is fundamentally different despite the mirror image seen in the spread design (i.e. selling instead of buying the OTM and buying instead of selling the FOTM IBM call option).

Because the options used to construct the vertical spread expire at the same time, there is no need to be concerned with rates of time value decay across different months (such as in calendar, or time spreads, which are covered in the horizontal and diagonal spreads section that follows). To visualize the profit/loss dynamics of a vertical call credit spread, let's return to the example of a vertical call spread with IBM options, where we bought the October 85 and sold the October 90, but this time for a hypothetical debit of $120. Now we will reverse this order and generate a credit spread in the process. As seen in Figure 1, the lower right-hand side of the profit/loss plot shows the maximum loss of $320 and upper left-hand side shows the maximum profit potential of $120.

The maximum loss of $320 results from the short October 85 call expiring in the money but having losses limited by the long side in the trade, the October 90 call.

Figure 1– Vertical bear call credit spread

Here we have taken in a net credit and will profit if the underlying stock closes below 86.20 (85 + 1.20 = 86.20) at expiration, which means we would want to have a neutral-to-bearish outlook on the stock when using this type of spread. The breakeven is determined by adding the premium of the spread (1.20) to the strike price (85). In other words, for a loss to occur, the stock has to trade up to the short strike in the bear call spread and exceed the credit collected (1.20).

For example, if IBM closes at 87 on expiration-day - the third Friday of October - the short option will be in the money and settle at 2.00 (87 – 85 = 2.00). Meanwhile, the October 90 strike will have expired out of the money and will be worthless. The credit spreader will be debited 2.00 (the amount the October 87 is in the money) at settlement, which will be offset only partially by the amount of premium collected when the spread was opened (1.20), for a net loss of -.80, or -$80. For each spread, there would be a loss of $80 in this scenario.

Whether using a vertical debit or credit spread, the same principles are at work on the put side. You could use a put debit spread (known as a bear put spread) to trade a bearish outlook (buying an ATM put and selling an FOTM put). On the other hand, if you had a bullish or neutral outlook, you could construct a put credit spread (known as a bull put spread), which involves selling an ATM put and buying an FOTM put to limit potential losses. The profit/loss profile is identical to the vertical call spreads outlined above.

Option Spreads: Horizontal Spreads

Related Articles
  1. Trading

    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.
  2. Trading

    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.
  3. Trading

    Trading Calendar Spreads In Grain Markets

    Futures investors flock to spreads because they hold true to fundamental market factors.
  4. Trading

    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 ...
  5. Trading

    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.
  6. Trading

    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. Investing

    How To Calculate The Bid-Ask Spread

    It's very important for every investor to learn how to calculate the bid-ask spread and factor this figure when making investment decisions.
  8. Trading

    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 ...
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center