What is Options Spread?

Options Spread Types

  • Horizontal Spread – A horizontal spread is created when an option using the same underlying security with the same strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and expiration date differs.Vertical Spread – A vertical spread has a different strike price; the expiration date and the underlying security remain the same.Diagonal Spread – Diagonal Spread consists of options with the same underlying security but the expiration date and the strike prices. A diagonal spread is a combination of the abovementioned horizontal and vertical spreads.

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Examples

#1 – Call Spread

A call spread consists of options of the same underlying security with a different strike price and expiration date.

The below example of a call credit spread is an options strategy that creates a profit when the value of the underlying security is expected to fall.

The initial stock price while entering a call credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ).read more is $163. Each option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more consists of 100 shares. The components of call credit spread are:

  • Sell call at $165 with expiration in the next monthBuy call at $180 with expiration in the next month

The entry price for the option is $1 (Sold at $165 for $2 and bought at $180 for $1)

The maximum potential profit for this options deal is:

  • = $1 x 100= $100

The call spread in this scenario is 15

Hence, the maximum potential loss is:

= (Call Spread – Entry price collected) x No of shares

  • = ($15-$1) x 100= $14 x 100=$1,400

#2 – Put Spread

Put spread consists of put optionsPut OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more of the same underlying security with a different strike price and expiration date.

The below example of a put credit spread is an options strategy that creates a profit when the value of the underlying security is expected to rise.

The initial stock price while entering a put credit spread is $330. Each contract consists of 100 shares. The components of the put credit spread are:

  • Sell put at $315 with expiration in the next month.Buy put at $310 with expiration in the next month.

The entry price for the option is $1.15 (Sold at $315 for $5.60 and bought at $310 for $4.45)

  • = $1.15 x 100= $115

The put spread in this scenario is 5

= (Put Spread – Entry price collected) x No of shares

  • = ($5-$1.15) x 100= $3.85 x 100=$385

Important Points

  • Debit and credit spreads create a profit for the investor if the premium of the option sold is higher than the premium of the option bought. The investor receives credit for such a transaction while entering the spread. If this were to be the opposite, the investor would be debited while entering the spread.When the spread is entered on debit, it is called the debit spread, whereas the spread entered in credit is called a credit spread.Spread combinations are complex options devised using strategies aimed at reducing the risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more while trying to earn a profit.Box spread consists of a bear put spread, and a bull call spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more refers to a trading strategy where the trader speculates a limited price appraisal of the stock. In such a trade, the risk involved is neutral; hence, the investor can enter a position while negating the risk altogether. In such a strategy, only the premium paid will be the maximum loss the investor has to bear.

To exemplify,

  • Long call – Oct 2019 – Strike 60Short put – Oct 2019 – Strike 60Short call – Oct 2019 – Strike 70Long put – Oct 2019 – Strike 70

Advantages

  • It helps investors to hedge their position and limit the amount of risk exposure.It allows investors to invest in an underlying assetAn Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more while trading on the spread position.The probability of earning a profit using the option spread is high while limiting the exposure to the risk in the investment.

Disadvantages

  • Trading on option spreads requires expertise and knowledge of the market, which is a bit tricky for new entrants.Just like the risk, which is minimized, the profit is also capped.The risk-to-reward ratio is minimal, meaning the risk taken for the amount of profit earned is massive.

Conclusion

  • Options spread the strategies used for trading options, which should not be confused with spread options, which are derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. While the strategies help make profits from the investment, they also minimize the risk involved.There are individual, and combination option spreads, and Investors or traders can use these strategies at their convenience.Trading on spreads requires knowledge of the market and expertise in the functionality of the strategies. These are highly complex strategies and can result in the loss of the entire investment if the market conditions are not gauged properly.

This has been a guide to what Options Spread is. Here we discuss the types of options, spread strategy, examples, advantages, and disadvantages. You can learn more about finance from the following articles –

  • Option ChainOption AgreementHow to Trade Options?Index Options