Option Spreads

“Options spreads – because sometimes you have to spread your options to keep your sanity.”

Options spreads refer to strategies that involve simultaneously buying and selling multiple options contracts on the same underlying asset with different strike prices, expiration dates, or both.

The goal of using options spreads is to create a more customized risk/reward profile compared to simply buying or selling a single option contract.

There are many different types of options spreads, each with its own unique characteristics and potential benefits.

Types of Options Spreads based on Direction

Each type of spread is chosen based on the trader’s expectations for the underlying asset’s price movement and their risk tolerance. Bullish and bearish spreads are directional strategies, while neutral spreads are non-directional, focusing more on volatility and time decay.

Bullish Spread

• A bullish spread is an options strategy designed to profit from an expected upward movement in the price of the underlying asset.
• It typically involves buying lower strike prices and/or selling higher strike prices, and can be constructed using either call or put options.

Bearish Spread

• A bearish spread is used to capitalize on an anticipated downward movement in the price of the underlying asset.
• This strategy often involves buying higher strike prices and/or selling lower strike prices, and can be implemented with either puts or calls.

Neutral Spread

• A neutral spread, often focused on achieving delta neutrality, is structured to profit from minimal movement in the underlying asset’s price.
• Delta neutrality means the position’s overall delta is close to zero, indicating that the position is relatively insensitive to small price movements of the underlying asset.
• Neutral spreads can involve combinations of call and put options and can be structured as straddles, strangles, or iron condors, among other strategies.
• The goal is to benefit from time decay or changes in volatility, rather than directional price movements.

Types of Options Spreads Based on Initial Cash Flow (Credit or Debit):

Long Spread

• A long spread, in options trading, refers to a position where the trader has paid a net premium to enter the trade.
• This is also known as a debit spread.
• It involves buying options that cost more than the options sold.
• Long spreads can be bullish, bearish, or neutral, depending on the strike prices and types of options used (calls or puts).
• Example: A long call spread (bullish) involves buying a call at a lower strike price and selling a call at a higher strike price. A long put spread (bearish) involves buying a put at a higher strike price and selling a put at a lower strike price.

Short Spread

• A short spread, also known as a credit spread, involves receiving a net premium when initiating the trade.
• This is also known as a credit spread.
• It typically consists of selling options that are more expensive than the options bought. In this case, the trader is selling options and would generally expect the spread to expire worthless, allowing them to keep the initial premium.
• Short spreads can have a bullish, bearish, or neutral market outlook.
• Example: A short call spread (bearish) involves selling a call at a lower strike price and buying a call at a higher strike price. A short put spread (bullish) involves selling a put at a higher strike price and buying a put at a lower strike price.

The terminology “long” and “short” in spreads refers to the net cost of entering the spread (paying a premium for a long spread vs. receiving a premium for a short spread).

1. All bullish spreads are long?

1. No, not all bullish spreads are long spreads. “Bullish” refers to the directional market outlook of the strategy (expecting the market to go up). A bullish spread can be either a long spread (debit spread) or a short spread (credit spread), depending on how it is constructed.

A spread can be long and bullish, long and bearish, short and bullish, or short and bearish, depending on the specific options used and their strike prices.

Types of Options Spreads based on Calls and Puts

Each type of spread (vertical, horizontal, diagonal) can be constructed with either calls or puts and designed to suit different market views and risk profiles. The choice depends on the trader’s expectations for the underlying asset’s price movement, time horizon, and volatility.

When we refer to a “put spread” or a “call spread” in options trading, it can imply a vertical, horizontal, or diagonal spread. The distinction depends on the specific structure of the trade.

Here’s a breakdown for each:

Put Spread

• A put spread is an options strategy comprised entirely of put options.
• It involves simultaneously buying and selling put options, typically with differing strike prices and some times differing expiration dates.

Call Spread

• A call spread is an options strategy that consists exclusively of call options.
• It involves the simultaneous buying and selling of call options, typically with different strike prices and sometimes with differing expiration dates.

Types of Options Spreads Based on Strategy Structure:

Options spreads can be categorized based on their structural composition, involving various combinations of buying and selling calls and puts. Here’s a detailed look at each type:

Vertical spreads

This involves buying and selling options at different strike prices but with the same expiration date.

Here are four most popular variations of vertical spreads:

• Bull Call Spread: Buy a call at a lower strike and sell a call at a higher strike.
• Bear Call Spread: Sell a call at a lower strike and buy a call at a higher strike.
• Bull Put Spread: Buy a put at a higher strike and sell a put at a lower strike.
• Bear Put Spread: Sell a put at a higher strike and buy a put at a lower strike.

Horizontal Spreads or Time Spreads or Calendar Spreads

This strategy involves buying and selling options with different expiration dates but the same strike price.

Here are four most popular variations of calendar spreads:

• Long Horizontal Call Spread:
  • Sell a call option with a near-term expiration date.
  • Buy a call option with a later expiration date.
  • Both options have the same strike price.
  • Benefits from the decay of the near-term option’s value if the stock price remains near the strike price.
• Short Horizontal Call Spread:
  • Buy a call option with a near-term expiration date.
  • Sell a call option with a later expiration date.
  • Both options have the same strike price.
  • Used when expecting an increase in volatility or a significant move in the underlying asset’s price before the near-term option expires.
• Long Horizontal Put Spread:
  • Sell a put option with a near-term expiration date.
  • Buy a put option with a later expiration date.
  • Both options have the same strike price.
  • Strategy benefits from time decay, especially if the stock price remains near the strike price.
• Short Horizontal Put Spread:
  • Buy a put option with a near-term expiration date.
  • Sell a put option with a later expiration date.
  • Both options have the same strike price.
  • Employed when an increase in volatility or a significant price movement in the underlying asset is expected in the short term.

We can also get Bullish Horizontal Call Spread but instead in reality, Long/Short Horizontal Spreads are more popular than Bull/Bear/Neutral Horizontal Spreads.

Diagonal Spreads

Different in both strike prices and expiration dates.Here are four most popular cases of diagonal spreads:

• Bullish Diagonal Call Spread:
  • Buy a long-term call option at a lower strike price.
  • Sell a short-term call option at a higher strike price.
  • Used when expecting a gradual increase in the underlying asset’s price over time.
• Bearish Diagonal Call Spread:
  • Buy a long-term call option at a higher strike price.
  • Sell a short-term call option at a lower strike price.
  • Employed when anticipating a gradual decrease in the underlying asset’s price.
• Bullish Diagonal Put Spread:
  • Buy a long-term put option at a higher strike price.
  • Sell a short-term put option at a lower strike price.
  • Utilized when expecting a steady decline in the asset’s price over a longer period.
• Bearish Diagonal Put Spread:
  • Buy a long-term put option at a lower strike price.
  • Sell a short-term put option at a higher strike price.
  • Used when anticipating a gradual increase in the asset’s price over time.

Straddle

Involves buying or selling both a call and a put option at the same strike price and expiration date.

• A Long Straddle is implemented when significant price volatility is expected, regardless of the direction.
• A Short Straddle is used when minimal price movement is anticipated in the underlying asset.

Strangle

Similar to a straddle, but the strike prices of the call and put options are different.

• A Long Strangle involves buying out-of-the-money (OTM) call and put options, suitable for situations where significant price movement is expected.
• A Short Strangle includes selling OTM call and put options, typically used when expecting little movement in the underlying asset’s price.

Ratio Spreads

These involve unequal numbers of bought and sold options. There are two ways Ratio Spreads can be classified!

Call and Put Ratio:

• Call Ratio Spread: More calls are sold than bought at a higher strike price.
• Put Ratio Spread: More puts are sold than bought, but at a lower strike price.

Buy and Sell Ratio:

• Front Spread:
  • Front Spreads involve selling more options than are bought.
  • They are typically used when a trader expects moderate movement in the underlying asset’s price.
  • The key here is to benefit from the decay of the option’s premium while managing risk with fewer purchased options.
  • Front Spreads can be either call or put frontspreads, depending on the trader’s market outlook.
• Back Spread :
  • Back Spreads involve buying more options than are sold.
  • This strategy is usually employed in situations where significant movement in the underlying asset’s price is expected.
  • Back Spreads aim to leverage large price swings and can be structured as call or put backspreads.
  • They carry a higher risk but also offer the potential for significant gains if the market moves as anticipated.

1. Can A Front Spread be a credit spread too?

1. Yes, a front spread can indeed be a credit spread. In a front spread, the number of options sold exceeds the number of options bought. This can result in either a net credit or a net debit to the trader’s account, depending on the premiums of the options involved. If the premium collected from the sold options is greater than the premium paid for the bought options, the front spread becomes a credit spread. Conversely, if the premium paid for the bought options is higher, it would be a debit spread. The defining characteristic of a front spread is the greater number of sold options, not the net cash flow.

Butterfly spreads

Structure: The payoff graph looks like a butterfly! Involve three different strike prices. A combination of a bull and a bear spread.

Here are various popular variations of Butterfly Spread –

• Call Butterfly Spread: Buy a lower strike call, sell two middle strike calls, and buy a higher strike call.
• Put Butterfly Spread: Similar to the call butterfly, but with put options.
• Iron Butterfly: Sell a call and a put at the same (usually at-the-money) strike, and buy a call and a put at equidistant strikes above and below the sold options.
• Broken-Wing Butterfly: Similar to a standard butterfly but with unbalanced strike prices, creating an asymmetrical position with different risk-reward characteristics.

Purpose: Primarily used to profit from low volatility. Ideal for neutral market outlooks, with limited risk.

Condor spreads

Structure: The payoff graph looks like a condor! Similar to butterflies but with four different strike prices.

Here are various popular variations of Condor Spread –

• Iron Condor: Sell a bull put spread (lower strikes) and a bear call spread (higher strikes).
• Long Condor Spread: Buy and sell calls or puts at four different strike prices, typically with equal spacing.
• Short Condor Spread: Inverse of the long condor, often entered for a net credit, expecting significant volatility but uncertain direction.
• Iron Condor Variant: Similar to the traditional iron condor but with unbalanced strikes or quantities to alter the risk-reward profile. [An “Iron Condor Variant” is a term used to describe variations of the traditional Iron Condor options strategy where traders intentionally adjust the strike prices or quantities of options to create a different risk-reward profile. ]

Purpose: Designed to profit from low volatility and range-bound markets. These spreads are beneficial when the trader expe

A butterfly spread typically involves three options contracts with different strike prices. A Condor Spread involves buying and selling four options contracts but typically at four different strike prices.

Benefits of Options Spreads

Risk management: By combining long and short options positions, options spreads can help manage risk and limit potential losses.

Increased profitability: Options spreads can be used to increase potential profits by capturing both the time decay and price movements of options contracts.

Flexibility: Options spreads can be tailored to specific market conditions and individual trading goals, providing traders with more flexibility in their options trading strategies.

Lower margin requirements: Since options spreads involve both buying and selling options contracts, the margin requirements are typically lower than for straight options trades.

Drawbacks of Options Spreads

However, options spreads also come with some potential drawbacks, including:

Limited potential profits: Since options spreads involve buying and selling multiple options contracts, the potential profits are often limited compared to straight options trades.

Increased complexity: Options spreads can be more complex than straight options trades, requiring a deeper understanding of options pricing and market conditions.

Higher transaction costs: Since options spreads involve multiple options contracts, the transaction costs can be higher compared to straight options trades.

Despite these potential drawbacks, options spreads remain a popular and effective strategy for many options traders. By carefully selecting the right options contracts and strike prices, and combining long and short options positions, traders can use options spreads to manage risk, increase profits, and take advantage of market volatility.