What are Options Spreads?
Options spreads form the basic foundation of many options trading strategies. A spread position is entered by buying and selling an equal number of options of the same class on the same underlying security, commodity, or financial instrument, but with different strike prices, different expiration dates, or both.
The three main classes of spreads are vertical spreads, horizontal spreads, and diagonal spreads. They are grouped by the relationships between the strike price and expiration dates of the options involved.
Vertical spreads, also known as money spreads, are spreads involving options of the same underlying security, commodity, or financial instrument having the same expiration month, but with different strike prices.
Horizontal spreads, also known as calendar spreads, or time spreads are created using options of the same underlying security, commodity, or financial instrument at the same strike prices but with different expiration dates.
Diagonal spreads are created using options of the same underlying security, commodity, or financial instrument having both different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.
Call and Put spreads
Any spread that is constructed using Calls can be referred to as a Call spread. Any spread that is created using Put options can be referred to as a Put spread.
Bull and Bear spreads
If a spread is designed to profit from a rise in the price of the underlying security, commodity or financial instrument it is a bull spread. If a spread is designed to profit from a fall in prices of the underlying security, commodity, or financial instrument, it is a bear spread.
Credit and debit spreads
If the premium of the options sold is higher than the premium of the options purchased, then a net credit is received when entering the spread. If the premium of the options sold is less than the premium of the options purchased, then a net debit is received. Spreads that are entered on a credit are known as credit spreads while those entered on a debit are known as debit spreads.
Ratio spreads and Backspreads
There are also spreads in which an unequal number of options are simultaneously purchased and written. When more options are written than purchased, it is a ratio spread. When more options are purchased than written, it is a ratio backspread.
Many options strategies are built around spreads and combinations of spreads. For example, a bull Put spread is basically a bull spread that is also a credit spread while the Iron Butterfly (see below) can be broken down into a combination of a bull Put spread and a bear Call spread.
A Butterfly spread is an option strategy combining a bull and bear spread. It uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both Puts and Calls can be used. This is a strategy having both limited risk and limited profit.
The Iron Butterfly is a neutral strategy similar to the Iron Condor (see below). However, in the Iron Butterfly an investor will combine a Bear-Call credit spread and a Bull-Put credit spread setting the sold Put and the sold Call at the same strike price (At-the-Money). Since the price of the underlying security, commodity, or financial instrument rarely falls at an exact strike price, Iron Butterflies can be traded when the sold Call is slightly In-the-money (ITM) or the sold Put is slightly In-the-Money (ITM).
Once a trader or investor has picked the strike price for the sold options, the trader or investor will look to purchase the same number of Call(s) further Out-of-the-Money (OTM) and the same number of Put(s) Out-of-the-Money (OTM). The sold Call(s) and Put(s) make up the 'Body' of the Iron Butterfly Position and the OTM purchased Call(s) and Put(s) make up the 'Wings' of the position.
Since the investor is selling an ATM Put and an ATM Call, and then purchasing an OTM Put and OTM Call for protection, a net credit is achieved. Because there are two spreads in this position (four options) there is an upper and lower break even point. A profit will be achieved if the stock price is below the upper break even and above the lower break even. The maximum profit for the Iron Butterfly position occurs if the stock price expires right at the sold options strike price. All four options will expire worthless and the investor will keep the entire net credit. The maximum risk is equal to the differences in strike prices between the two Calls or the two Puts (whichever is greater) minus the initial net credit achieved.
A box spread consists of a bull Call spread and a bear Put spread. The Calls and Puts have the same expiration date. The resulting portfolio is delta neutral. For example, a 50-60 March box consists of:
- Long a March 50-strike Call
- Short a March 60-strike Call
- Long a March 60-strike Put
- Short a March 50-strike Put
A box spread position has a constant payoff at exercise equal to the difference in strike values. Thus, the 50-60 box example above is worth 10 at exercise. For this reason, a box is sometimes considered a "pure interest rate play" because buying one basically constitutes loaning some money to the counterparty until exercise. In essence a box places the trader long the inside of the box and short the outside of the box. When all sides of the box are in place, it is not possible to experience a loss unless the box is dismantled prior to expiration.
Building a fence by using options is an alternative to consider. A fence is built around the net price needed for a satisfactory result. A minimum price is set under which the price cannot fall and a maximum price is set over which the net price cannot rise. To build a fence a Put option is purchased with a strike price just below the current price of the underlying security, commodity, or financial instrument, and a Call option is sold at a strike price above the current price of the underlying security, commodity, or financial instrument. The Put option establishes a floor price for the underlying. The Call option establishes a ceiling price.
The Condor spread is similar to a butterfly spread. A condor is an options strategy that has a bear and a bull spread, except that the strike prices on the short call and short put are different. The purpose of the Condor spread is to earn limited profits, regardless of market movements, with a small amount of risk. The Iron Condor is an advanced options strategy that involves buying and holding four different options with different strike prices. The iron condor is constructed by holding both a long and short position in two different Strangle strategies. A strangle is created by buying or selling a Call option and a Put option with different strike prices, but the same expiration date. The potential for profit or loss is limited in this strategy because an offsetting strangle is positioned around the two options that make up the Strangle at the middle strike prices.
This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security from which the options are derived. An iron condor is very similar in structure to an iron butterfly, but the two options located in the center of the pattern do not have the same strike prices. Having a Strangle at the two middle strike prices widens the area for profit, but also lowers the profit potential.