Spreads - Option Spread Trading

Understanding Spreads and Options

The purpose of engaging spread trading is to either make money on the premium difference (money spent and received) or to earn profit on the options themselves being traded or exercised.

A debit spread is when the options that are bought and sold result in a loss on the premiums. The investor has spent more for the option purchased than the option shorted.

This is a debit spread since the $400 paid exceeds the $200 received. There is a $200 Debit on this spread. The investor in this case is looking to make a profit on the future value of the options. Since these are call options, the investor is bullish on the market (wants the market on ASD to rise).

The market rising will allow the investor to take advantage of the increased premium or to exercise the options. The long option allows the investor to purchase the stock at 40 and the short option carries an obligation to sell at 45. If these were to happen, the person could make 5 points on the stock (strike price difference) minus the initial debit loss ($200). This equals the maximum gain potential ($300). The maximum loss is if both options expire worthless, resulting in a $200 loss.

A credit spread works the opposite way. The investor is looking to gain on the premiums and then is hoping the options expire worthless. Using the same example above, the numbers are the same, but the gain and loss would be reversed. The person would be Long the 45 paying $200 and Short the 40 call, gaining $400. The $200 is now a credit and is the gain. If the options were exercised, the 5 point difference in the strike prices would be a loss (buying at 45 and selling at 40). The trader would be bearish on the market for a call credit spread like this. Trading of credit call spreads is higher in a bear market.

A vertical or price spread is when the strike prices are different, but the expiration months are the same. The above examples would be considered vertical spreads.

A horizontal spread is when the strike prices are the same, but the expiration months are different. The trader can make money on this type of spread because even thought the strike prices are the same, the option with the longer expiration month will have a higher premium, so there is still a "spread".

When a spread has months and strike prices that are different, it is defined as a diagonal spread. The options are vertical and horizontal at the same time.

All in all, spreads are fairly conservative - as far as options are concerned. A long position is covered by a short position, so large or unlimited losses do not normally occur.

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