What is an Option Spread? Meaning, Types & Examples
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- Updated On:19-Feb-2021
- Replies:2
Short Answer
Option Spreads are usually used to hedge a position and try to increase the chances to make money. By doing this we limit our profits but most importantly we minimize our losses that is the most important part in trading, which is to preserve our capital.
Detailed Answer
An option spread is an options strategy involving the sale and purchase of options of different strike prices and/or different expiration dates on one underlying asset and are of the same type in which all options are either call or put options. They are the elementary blocks of almost all options strategies. It is used to reduce the risk or stake on various market outcomes using two or more options.
For example:
Buy 3 call options at the strike price of 60.
Sell 3 call options at the strike price of 65.
*With Same expiration dates
Option Spread Features
- They only differ in strike price.
- They are on the same underlying asset.
- They have same number of long and short options involved because we sold the same number of call and put options.
Types of Option Spreads
There are three types of Option spreads:
1. Vertical spread:
They are the option strategies that only consists of options that differ in regard to strike price. In this, an individual buys one option and sells another using both calls and put at a higher strike price. It has four types:
a) Bear call spread: It is selling a call option but at a higher strike price than purchasing another call option with same expiration.
b) Bear put spread: It is purchasing a put option at a lower strike price than selling another put option.
c) Bull call spread: It is buying a call option at a higher strike price while simultaneously selling another call option.
d) Bull put spread: It is writing a put option at a lower strike price while simultaneously purchasing another put option.
2. Horizontal spread or Calendar Spread:
These are the option strategies that only differ in expiration dates i.e., same strike price and same underlying asset. With limited risk, the spread can also be used as a tool for generating substantial leverage. There are four types:
a) Buy 1 call (Front-Month)
Sell 1 call (Back-Month)
b) Buy 1 put (Front-Month)
Sell 1 put (Back-Month)
c) Sell 1 put (Front-Month)
Buy 1 put (Back-Month)
d) Sell 1 call (Front-Month)
Buy 1 call (Back-Month)
(Front-month is the early expiration date and Back-month is the later expiration date.)
Calendar strategy are not directional strategy but take advantage of movement in implied volatility for example long calendar spread try to profit from increase in implied volatility and for short it is the opposite.
3. Diagonal Spread
These are basically the combination of both vertical and horizontal spread and differ in strike price and expiration date. These are generally most complex of the three types of spreads as it forms various possibilities. They take advantage of the price movement asked, the implication of volatility and time. In simpler words, diagonal spread is a method of options that includes purchasing a call or putting an option at one strike price and one expiration and selling/buying a second call or placing it at a separate strike price and expiration.
Here is the example which will help in understanding it better:
4 Short calls 4 Long calls
Strike price:50 (Back-Month)
Strike price:45 (Front month)
- They have different strike prices and different expiration dates.
- Only call options are there. (i.e., only 1 type of options are there)
- Same number of long and short options.
By this you can understand how a diagonal spread looks like.
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Discussion (1)
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Options spread is a basket of options contracts with different variables to minimize losses and limit profits. It's a great way of earning profits consistently and not having to face losses. But then the buying and selling of options contracts must be executed with utmost precision to book profits of any type.