What Are Option Spreads?
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Vertical | Horizontal | Diagonal
Option Spreads
Learn how to set up and profit from Option Spreads
Option spreads, along with calls and puts, are the building blocks to almost all option trading strategies.
An options spread is an options strategy involving the purchase AND sale of an option at different strike prices OR different expiration dates.
All options spread are set up as the same type. They are either all call options or all put options and on the same underlying asset
They differ in only the expiration date or the strike price.
They are set up with the same number of buy options as sell options. If you buy 5 call options, you will also sell 5 call options.
A bullish long call diagonal spread is set up by
- vertical spreads
- horizontal spreads
- diagonal spreads
Vertical spreads are options that differ only in terms of strike price. They will have the same expiration and are of the same type ( all calls or all puts )
- call spreads
- put spreads
- —————-
- bull spreads
- bear spreads
- —————-
- credit spreads
- debit spreads
Option Basics
Buying a Call
Different Spreads for Different Conditions
- Vertical spreads set ups differ in terms of strike price
- Horizontal spreads differ in terms of expiration dates
- Diagonal spreads differ in terms of both- strike price and date
Vertical spreads –
- use if you want to take advantage of price movement
Diagonal and horizontal spreads –
- use if you want to take advantage of changes in volatility
Option Basics
How Does a Call Option Change with Volatility and Time
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
- Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
- Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
- Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
- Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega
Buying a Call
Management and Adjustments
- Maximum Profit Potential: Unlimited
- Maximum Loss Potential: Premium Paid for the Call
- Expiration Breakeven Price: Call Strike + Premium Paid for Call
- Estimated Probability of Profit: Less Than 50%
- Assignment Risk?
Credit Spreads
- Max Profit= premium
- Maximum Risk = ( width of the strikes – premium )
Debit Spreads
- Max Profit= ( width of the strikes – premium )
- Maximum Risk = premium
Vertical Spreads
How Do You Set Up a Vertical Spread?
Bear Call Spread ( credit spread )
- sell a call at lower strike while buying a call at a higher strike
- buy a call at a lower strike while sell a call at a higher strike
Bull Put Spread ( credit spread )
- Sell a call at a higher strike while buying a put at a lower strike
Bear Put Spread ( debit spread )
- Buy a put at a higher strike while selling a put a a lower strike
Long Horizontal Spread - neutral strategy
Vertical Spreads
How Do You Set Up a Horizontal Spread?
Short Call Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Short Put Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Long Horizontal Spread - neutral strategy
Diagonal will vary in both expiration date as well as strike price
- Diagonal spreads try to take advantage of both price movement, implied volatility, and time.
- The most complicated of the different spreads
Vertical Spreads
How Do You Set Up a Diagonal Spread?
Diagonal will vary in both expiration date as well as strike price
- Set up as vertical spreads but at different strike prices and expirations
- sell a call in a back or distant month
Short Call Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Short Put Calendar Spreads ( credit spread )
- buy a call in a front month
- sell a call in a back or distant month
- sell a call in a front month
- buy a call in a back month
- profit from increasing implied volatility
Option Basics
Tips and Tricks
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
Buying ITM -in the money call options will
- Increase the amount of directional exposure since in the money options have deltas closer to +1
- ITM options are less affected by theta decay
Introduction
Same risk profile as a short put
Use to reduce the cost basis if you want to purchase a stock by selling a put against the purchase
You need to think of this in contrast to buying a stock outright
Setting Up a Covered Call
FYI- Would rather use strategies that sell premium rather than using debit spreads
Set up in low volatility environments
Straddle the stock price
Buy an ITM option and Sell an equidistant or slightly closer OTM option
Set up so that the break even is just around the stock price or ideally even just a little bit better
Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success
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