Directional Spreads

Derivatives are financial weapons of mass destruction. – Warren Buffet

Although volatility spreads are based on the foundation of delta neutrality, it will be unfair to ignore the very basics of directional spreads.

Bull and bear spreads are different from volatility spreads in their purpose and the way they are constructed.

Bull spread and bear spread:

• Bull spread and bear spread are used to take a directional view on the underlying asset.
• A bull spread is a strategy that involves buying a call option at a lower strike price and selling a call option at a higher strike price.
• A bear spread is a strategy that involves buying a put option at a higher strike price and selling a put option at a lower strike price.
• Both bull and bear spreads limit the potential profit and loss of the trade.
• The maximum profit is achieved if the underlying asset price closes at or above the higher strike price for a bull spread, or at or below the lower strike price for a bear spread.
• The maximum loss is limited to the premium paid for the options.

Volatility spread:

• A volatility spread is a strategy used to take a view on the implied volatility of the underlying asset.
• A volatility spread involves buying an option with a lower implied volatility and selling an option with a higher implied volatility.
• The goal of a volatility spread is to profit from the difference in implied volatility between the two options.
• The maximum profit is achieved if the implied volatility of the options converges to the expected level.
• The maximum loss is limited to the premium paid for the options.

In summary, bull and bear spreads are used to take a directional view on the underlying asset, while volatility spreads are used to take a view on the implied volatility of the underlying asset.

The Bull Spread and The Bear Spread are directional. So, it is known as Directional Spread in short.