What Are Options Spreads?

Thu Jul 22, 2021, 02:51 pm | by Dan Schmidt | No comments

The term ‘spread’ can have several different meanings depending on where it is used in the financial industry. A spread is often used to refer to the difference in bid and ask prices on an individual security. If the ask price is much higher than the bid, the security has a wide spread and is likely very illiquid. 

In sports betting, the spread is created by oddsmakers to attempt to bring two teams into equilibrium from a gambling perspective. For example, the Milwaukee Bucks were favored to beat the Phoenix Suns by 5 points in Game 6 of the NBA Final, meaning the Bucks must win by 5 or more to cover the spread.

But when it comes to options markets, the term spread has a much different definition. Utilizing options spreads is a diversification strategy when trading stock options, which can be much more volatile than their underlying equities. Using options spreads properly can minimize risk and give your trades a higher likelihood of profitability, but they can be complex and expensive trading strategies if they aren’t accurately initiated.

Definition of Options Spreads 

An options spread is a type of trade where an investor both buys and/or sells (writes) options on the same underlying security. But instead of simply buying a call and hoping the stock appreciates, spread traders buy or sell calls (or puts) at different strike prices or expiration dates. By utilizing the spreads between different options contracts, the investor can potentially limit their downside, lower their margin maintenance requirements, or reduce the overall costs of entering a trade.

The spread in options spread trading refers to the difference between the strike price or expiration date of two options on the same underlying security. Options spread trades always require at least two or more legs – for example, you could buy and sell Facebook Inc (NYSE: FB) calls at two different strike prices if you thought the stock would rise. Buying a call gives you the right to purchase 100 shares at the strike price; selling a call allows you to collect a premium and minimize the capital needed to purchase the previously stated call options.

Options spread trading can be quite confusing at first glance, so it’s important to dig into the details of each strategy and remove some of the vagueness and complexity. Options spreads are definitely a more advanced type of trading, but they’re a little easier to understand when broken down in plain English. Let’s try a few examples.

Types of Options Spreads Strategies

The following are the three basic types of option spread strategies. Each of these can be expanded upon for more complex, multi-leg trades, but they all can be traced back to one of these three techniques:

Vertical

A vertical options spread means buying and selling calls or puts of the same underlying security, but with different strike prices. The expiration date on both options is the same on a vertical spread. It’s called a vertical spread due to the vertically-listed strike prices and bearish or bullish bets can be made with vertical spreads.

A common example is the bull call spread: a trader will buy a call option at a specific strike price while writing a call with a higher strike price. By purchasing one call and selling another with a higher strike price, the trader limits the downside of the trade through the premium on the written call but still profits if the underlying stock goes up in price. Maximum profit in this case would be the spread between the lower and higher strike prices (minus the premium on the purchased call).

A bear call spread works in reverse: the call with the lower strike price is sold while the one with the higher strike price is purchased. In this case, the trader is seeking only to profit from the premium on the written call with the purchased call expiring worthless.

Horizontal

If vertical spreads use different strike prices, horizontal spreads naturally use different expiration dates. Often known as calendar spreads, these trades don’t seek to profit from a strong move up or down. Horizontal spreads attempt to profit from implied volatility while minimizing the effect of time.

Here’s an example of a horizontal spread: a trader buys a 345 FB 9/17 call for $1540 and sells a 345 FB 8/20 call for $1135. This creates a debit of $405 in the account.

If FB fails to reach $345 by 8/20, the sold call expires worthless and the trader profits from the premium while still holding the 9/17 and profiting from any upward move between August 20 and September 17. 

Diagonal

You can probably guess what a diagonal spread is based on the definition of the previous two. Diagonal spreads are when a trader purchases two call or put options on the same security, but with different strike prices AND expiration dates. Diagonal spreads can be bearish or bullish and result in account debits or credits depending on the type of trade.

Here’s a long call diagonal spread: a trader purchases an in-the-money call with a specific expiration date while selling an out-of-the-money call with a closer expiration date. The key to this trade is the spread on the strike prices. You’ll want the spread between the strikes to be less than the debit made against your account value. The premium pocketed from the out-of-the-money option makes owning the in-the-money option less expensive, but you’ll still profit should the underlying security increase.

Why Use Options Spreads

  1. Reduce net cost of entering – By using spreads, traders can limit the amount they pay in premiums by collecting a premium on a lesser valued option. By selling a less valuable option, traders minimize the costs involved in opening a position without taking away their upside.
  2. Minimize risk – Using spreads means a reduction in maximum profit. For example, if you buy a single call option on a stock and the shares quickly double, you’ll make more money than if you bought AND sold calls on a vertical spread. But by limiting upside, spreads also limit downside. By buying and selling multiple options, a trader can reduce their risk exposure while still maintaining a leveraged position.
  3. Bet on various outcomes – Markets can move up, down, or sideways for any length of time. By using option spreads, traders can take advantage of any market conditions and make profit. Bull market in stocks? Use bull call spreads on index options. Sideways trading sessions? Use a horizontal spread to take advantage of the time between option expirations. Traders can profit on a number of different outcomes using spreads.

Final Thoughts 

Options trading is inherently risky since leverage is involved, but spread trading can limit some of these risks through careful trade construction. Spread traders can minimize the downside of a leverage position or decrease the costs of entering a long or short trade. Just be sure to understand the intricacies of spread trading strategies before risking your capital on them. Spread trading isn’t a path to free money. In fact, if you don’t compose your trades properly, you won’t limit your losses – you’ll multiply them.

If you aren’t familiar with spread trading, a little practice on a simulator is a good idea to get started. Options spread trading can be difficult to explain on paper and some investors will learn faster by seeing the actual trades in action. Just don’t expect practice to make perfect right away.