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Options Spread: What It Is and How to Use It

A n options spread is a relatively advanced options strategy. Your overall views of the market, as well as your preferences for risk and reward, can determine the type of options spread you use. A few different types of options spread exist for traders to use.

Key takeaways:

  • An options spread involves purchasing or selling two or more options that cover the same underlying asset, such as a stock.
  • You’ll find three main types of options spreads: vertical spreads, horizontal spreads, and diagonal spreads.
  • While horizontal and diagonal spreads are both calendar spreads, vertical spreads only use different strike prices.
  • Vertical spreads include both bull and bear call spreads as well as bull and bear put spreads.

What Is an Options Spread?

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An options spread is a strategy that usually involves two or more options on one single underlying asset. You can use a spread on options at different strike prices. A spread can also occur between prices of the same asset at different points in time, which is known as a calendar spread.

The combination of options is typically based on the same underlying asset. In other words, if you buy calls for stock in Starbucks, you would also sell calls for the same Starbucks stock.

Spread options trading refers to the act of buying and selling the same kind of option at the same time. You can take part in spread options trading with both call options, which give you the right (but not the obligation) to buy something in the future, and put options, which give you the right (but not the obligation) to sell something in the future.

You must buy and sell the same kind of option with a spread. So, if you’re buying a call option, you’ll also sell another call option. You can, however, use various combinations of strike prices and/or expiration dates.

Types of Options Spreads

You can classify options spreads into three main types:

  1. Vertical spreads.
  2. Horizontal spreads.
  3. Diagonal spreads.

Vertical Options Spreads

You construct a vertical options spread using simple options spreads. These spreads require you to:

  • Buy and sell the same types of options (either calls or puts).
  • Use the same expiration date.
  • Use the same underlying asset.
  • Use different strike prices.

Each spread of this type has two legs: One leg is buying an option, while the other is writing an option. This option position will give you either a credit or a debit. A debit spread occurs when putting on a trade costs money, while a credit spread provides the trader with a net premium credit.

Horizontal Options Spreads

Commonly referred to as a time spread or calendar spread, a horizontal spread requires you to:

  • Buy and sell the same types of options (either calls or puts).
  • Use the same strike price.
  • Use the same underlying asset.
  • Use different expiration dates.

The different expiration dates lead to the calendar spread and time spread names.

Diagonal Options Spreads

If you’re using a diagonal options spread, you will need to:

  • Buy and sell the same types of options (either calls or puts).
  • Use the same underlying asset.
  • Use different expiration dates.
  • Use different strike prices.

Both diagonal and horizontal spreads are examples of calendar spreads. Calendar options spreads use advanced strategy. Traders may profit both from the decay in option prices as well as the differential between contract months and downward directional movement of an underlying stock.

Understanding the Vertical Options Spread

If you’re just starting out with options trading, vertical spreads can offer a good place to dive in. Let’s explore the types of vertical spreads a bit more in-depth.

Call Spreads

You can have either a bull call spread or a bear call spread when you’re trying a vertical options spread:

  • Bull call spreads: You use a bull call spread when you purchase a call option and sell another call option at the same time, both on the same underlying asset and with the same expiration date. This type of call spread requires a higher strike price. Because a bull call spread is a debit spread, you restrict the maximum loss to the net premium you pay for a position. Your maximum profit will equal the difference in strike prices of your calls, less the net premium you pay for a position.
  • Bear call spreads: You use a bear call spread when you sell one call option and purchase another call option at the same price at a higher strike price. Both options have the same expiration date. Because a bear call spread is a credit spread, you restrict your maximum gain to the net premium you receive for a position. Your maximum loss equals the difference in strike prices of the calls, less the net premium you receive.

Put Spreads

Likewise, you can have either a bull put spread or a bear put spread with a vertical options spread:

  • Bull put spreads: You create a bull put spread when you write a put option and buy another put option with a lower strike price at the same time. Both options need to have the same expiration date. As a bull put spread is a credit spread, it restricts your maximum gain to the net premium you receive for your position. Your maximum loss equals the difference in strike prices of the puts, less the net premium you receive.
  • Bear put spreads: You create a bear put spread by buying a put option and selling another put option with a lower strike price at the same time. Again, both options have the same expiration date. A bear put spread is a debit spread, restricting your maximum loss to the net premium you pay for your position. The maximum profit equals the difference in your strike prices, less the net premium you pay to put on this position.

Why Use a Vertical Options Spread?

Traders typically choose to use a vertical spread for one of two reasons:

  1. They want to reduce the premium amount payable (with a debit spread).
  2. They want to lower the risk of an option position (with a credit spread).

When there’s elevated overall market volatility or a specific stock has high implied volatility, option premiums can get expensive. Although a vertical spread puts a cap on the maximum gain you can make, it also cuts down the cost of the position significantly when you compare it to the profit potential of a standalone call or put. Thus, you can use a debit spread during times of elevated volatility because volatility on one leg will offset the other leg’s volatility.

Credit spreads, on the other hand, greatly bring down risk when writing options, which is key because option writers typically take on big risks to bring home relatively small amounts on option premiums. One disaster on a trade can override gains made on tons of successful previous trades.

Writing uncovered or naked calls is one of the riskiest strategies when it comes to option strategies — theoretically, potential loss is unlimited. Although writing put options is less of a risk comparatively, aggressive traders who write puts on many options could get stuck with a large amount of expensive stocks if the market crashes suddenly. Credit spreads help to mitigate these risks, though the cost of mitigating risk in this way is a lower amount of option premium.

How To Decide Which Vertical Spread to Use

When considering your strategy, you’ll want to think about a few different factors:

  • Are you bullish, or are you bearish?: Think about whether you’re positive or negative on the markets. If you’re especially bullish, you might think about standalone calls instead of using a spread. However, if you’re expecting just a modest upside, you could think about using a bull call or put spread. Similarly, if you’re modestly bearish or you want to bring down the cost of hedging long positions, you could use a bear call or put spread.
  • What is your view on volatility?: Do you think volatility will rise or fall? If you’re expecting rising volatility, that might mean you should try debit spread strategies that favor an option buyer. If you’re anticipating declining volatility, that situation improves odds for an option writer and might signify a good time for a credit spread strategy.
  • What is your preference for risk and reward?: If you lean toward taking limited risk with the possibility of greater reward, you may have an option buyer’s mindset. If you’re seeking limited reward while taking on potentially bigger risks, you may have an option writer’s mindset.

O ptions spreads give you a way to buy or sell two or more options at the same time. Different strategies for creating spreads can help you to limit exposure to risk or overcome a fear of losing out on the market. All in all, options spread strategies make it easier to create a more dynamic trading strategy.