>> Option Spreads

Contents of this article –

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

7) Option Spreads: Diagonal Spreads

8) Option Spreads: Tips And Things To Consider

9) Options Spreads: Conclusion

Introduction

Too often, new traders jump into the options game with little or no understanding of how options spreads can provide a better strategy design. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we’ve put together the following options spread tutorial, which we hope will shorten the learning curve.

The majority of options traded on U.S. exchanges take the form of what are known as outrights (i.e. the purchase or sale of an option on its own). On the other hand, what the industry terms complex trades comprise just a small share of the total volume of trades. It is in this category that we find the complex trade known as an option spread .

Using an option spread involves combining two different option strikes as part of a limited risk strategy. While the basic idea is simple, the implications of certain spread constructions can get a bit more complicated.

This tutorial is designed to help you better understand option spreads, their risk profiles and conditions for best use. While the general concept of a spread is rather simple, the devil, as they say, is always in the details. This tutorial will teach you what option spreads are and when they should be used. You’ll also learn how to assess the potential risk (measured in the form of the Greeks — Delta. Theta. Vega ) involved with the different types of spreads used, depending on whether you are bearish, bullish or neutral.

So, before you jump into a trade you think you have figured out, read on to learn how a spread might better fit the situation and your market outlook. If you need a refresher course on the basics of options and option terminology before you delve any deeper, we suggest you check out our Options Basics tutorial.

Selling & Buying to form a Spread

When you buy or sell a call or a put option, you are using only one option strike and, by definition, trading in a single contract month, with one expiration date and always only one underlying. The Greeks apply to that one option only. However, depending on the type of spread trade you might use, you may be incorporating not just different strikes, but multiple months and, in some cases (when trading futures options), multiple underlying contracts.

But before we get ahead of ourselves, let’s start by thinking in terms of a basic spread and what that means.

If we were to reduce the idea of a spread to its most basic or essential characteristic, it would have to be its use of two option contracts, known as the legs of the spread. Using two legs simply means that you are combining, for example, a call option that you buy (sell) with a call option that you sell (buy). Therefore, you are taking both sides of the market in all spreads (buying/selling or selling/buying). That is the easy part.

While the spread is a simple concept, it can become a bit more difficult in practice — especially in terms of the implications for profit/loss given a directional move of the underlying. Many traders are less likely to consider risk dimensions measured by Theta and Vega, but that doesn’t make them any less important. These Greeks, shown in Figure 1, are important measures of risk, so let’s take a moment to review them. (For further insight, see Getting To Know The Greeks and Using The Greeks To Understand Options .)

Delta is a measure of exposure to price changes, Vega is a measure of exposure to volatility changes and Theta is a measure of exposure to time value decay. (For more on this, see The Importance Of Time Value .) Looked at in terms of a spread with two legs, these risk measures refer to the entire position (i.e. position Delta, position Theta, position Vega). The position Greeks will be explained further below, as we examine each type of spread discussed in this tutorial.

Since a spread trade always involves the use of more than one option strike price, let’s examine what this means in terms of the Greeks. Remember that when you buy a call, for example, you are exposing yourself to the risk of a wrong-way move of the underlying (i.e. you don’t want the stock to fall). Or perhaps you face risk from a too-slow rise of the underlying and potential loss from time value decay (i.e. you want a bullish move of the underlying and you want it as quickly as possible).

But when you construct a spread, which involves both selling and buying options as two sides or legs of the spread, you are taking the other side of the trade in the underlying. This fundamentally changes the risk you face. Now, since you have sold a call and bought a call (for example), you have less risk from a fall in the market and from decay of the premium (since the call you sold will profit from both these developments), instead of facing the risk of a wrong-way move as mentioned above when in a long call, or a market that moves too slowly in your intended direction.

In other words, the purchase of the call in question, given a bullish outlook, is subsidized by the sale of a further out-of-the-money (FOTM) call (the time premium collected offsets the purchase price of the call purchased). While limiting risk (we will come back to this below with an example), it also limits exposure to time value decay (the short call gains with passage of time) and downside price movement (the short call gains here, too).

You might be wondering how you can profit from a spread if you buy and sell a call (or put) that both gains and loses with not just wrong-way moves or no movement, but also with the correct move in the correct time frame. The answer can be found by looking at the different strikes chosen and the resulting differential position Theta, Delta and Vega resulting from any particular spread construction. The word differential is a fancy way of describing the net Theta, Delta or Vega values (what we have after combining the individual Greek values on each leg) of the spread. If you are confused, the examples below will help to make this somewhat abstract discussion more concrete.

Remember that with an outright option you have a measure of Theta, Delta and Vega (among other risk measures known as the Greeks). When you construct a spread using different option strikes, you in effect are combining the Delta, Vega and Theta of each strike into one trade, giving you a position Greek. For example, when you combine the two Delta values of each option in a spread, you now have a net Delta, or position Delta, which can be negative (net short the market) or positive (net long the market). This is true for Vega and Theta, as well as the other Greeks, but the implications of the signs on the values are different, as we will discuss later. (For more insight, see Going Beyond Simple Delta: Understanding Position Delta .)

Before looking at the most commonly used spreads using call and put options, let’s take a closer look at our idea of position Greeks and explore what this means in terms of the risk/reward story.

Vertical Spreads

Limiting Risk with Long and Short Options Legs

We have seen that a spread is simply the combination of two legs, one short and one long (but not necessarily in that order), in our simple call spread example in the previous chapter. Now let’s get into a little more detail in order to begin to understand how a spread can limit risk. After looking at the risk and reward of spreads versus outrights, the next step will be to explore how each spread works and what markets work best with available spread constructions, keeping in mind the changing risk profiles of each spread from the point of view of the position Greeks mentioned in the previous section.

Taking both sides in an option trade in the form of a spread creates an opposing dynamic. The long option risk is counterbalanced by the short option reward and vice versa. If you were to buy an out-of-the-money (OTM) call option on IBM and then sell a further out-of-the-money (FOTM) call option, you would have constructed what is known as a vertical call spread (we will discuss vertical spreads in all their forms in more detail later), which has much less risk than an outright long call.

When you combine options in this manner, you have what is known as a positive position Delta trade, as seen in Figure 2 of the previous chapter. Negative position Delta refers to option spreads that are net short the market. We will leave neutral position Delta spreads aside for the moment, returning to neutral spreads toward the end of this tutorial.

If IBM trades lower, for example, you would lose on the long OTM call option and gain on the short FOTM call option. But the gain/loss values will not be equal. There will be a differential rate of change on the option prices (i.e. they will not change by the same amount given the hypothetical drop in IBM stock, the underlying). The reason for the different rates of change in the prices of the two legs of the spreads is easy to understand – they are options with different strikes on the call options strike chain and, therefore, will have different Delta values (we will talk about Theta and Vega later).

Therefore, when IBM drops, the OTM long call option, having the larger Delta because it is closer to the money, will experience a bigger change (drop) in value than the change (drop) in the FOTM short call option. All other things being equal, a drop in IBM will cause the option spread value to decline, which in the case of this type of spread (a bull call debit spread ) is always going to mean an unrealized loss in your account. But the loss is smaller than would have been the case if long just the OTM call.

On the other hand, if IBM rises, the opposite will occur. The OTM long call option will experience a greater rise in price than the FOTM short call option’s price. This causes the spread price to increase, resulting in unrealized profits in your account. In both cases, for simplicity, we assume that the IBM move occurs just after taking the spread position and, therefore, time value decay has not become a factor yet.

As you can see, the risks of being wrong are reduced with a spread, but this is balanced with reduced reward if you are correct. Obviously, as with most things in life, there is no free lunch. Nevertheless, a spread trade does offer greater control of unexpected market outcomes and can allow you to better leverage your capital, leaving more capital available to use with another trade or trades. This conserved capital allows for greater diversification, for instance. And with credit spreads (which will be discussed next), which profit from time value decay, the use of a spread can increase the power of your margin dollar. That is, your risk-reward ratio can be improved in many cases.

Having seen how spreads work at a very basic level, let’s turn to a closer examination of the mechanics of spreads with a look at what are called debit spreads, and then their reverse, spreads that generate a net credit in your account when opened, or credit spreads.

Debit Spreads Structure

Spreads, as we have seen, are constructed by taking positions on the long (buying the option) side while simultaneously taking a position on the short (selling the option) side of the market. Figure 1 lists the major characteristics of long options which, as you may already know, offer unlimited potential profits with limited risk measured in the form of the premium paid for the option. And as you can see in Figure 2, selling options presents just the reverse, that is, unlimited potential losses with limited potential profit.

Therefore, when we combine these into a spread, the unlimited risk posed by selling an option (such as our FOTM IBM call option from previous examples), is hedged by the purchase of the OTM IBM call. Clearly, if IBM moves up to the strike of the sold option and it gets in the money, it only means that the long option in the spread will be gaining, but only profitably up to the strike of the short option (where gains are offset with losses, ultimately at 100%). If at expiration the short option is in the money, the long option will have offset any losses incurred on the short option. So where does the profit arise?