Option Spreads Explained

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What are different types of options spreads?

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An option spread is a simultaneous Buy and Sell of options of the same underlying asset. The strike prices and expiration dates are different in such spreads.

Types of Option Spreads are-

  • Vertical spreads- When an option spread is created using Options of same underlying, expiry but of different strike prices, it is called a vertical spread.
  • Horizontal spreads- Also called Calendar spreads, these are created using options of the same underlying, strike prices but different expiration dates.
  • Diagonal spreads- These are created using options of the same underlying but different strike prices and expiration dates.
  • Call spreads- A spread created using only Call options are called Call spreads.
  • Put spreads- A spread created using only Put options are called Put spreads.
  • Bull spreads- An Option spread created to make a profit from an increase in the price of the underlying.
  • Bear spreads- An Option spread created to make a profit from a downward movement in the price of the underlying.
  • Credit spreads- A spread which results in higher premium received than paid i.e. net premium credit is called a credit spread.
  • Debit spreads- A spread which results in higher premium paid than received i.e. net premium debit is called a debit spread.

Option spreads can be entered on a net credit or a net debit. If the premiums of the options sold are higher than the premiums of the options purchased, then a net credit is received when entering the spread. If the opposite is true, then a debit is taken. Spreads that are entered on a debit are known as debit spreads while those entered on a credit are known as credit spreads.

Bull call spread

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To profit from a gradual price rise in the underlying stock.

Explanation

Example of bull call spread

Buy 1 XYZ 100 call at (3.30)
Sell 1 XYZ 105 call at 1.50
Net cost = (1.80)

A bull call spread consists of one long call with a lower strike price and one short call with a higher strike price. Both calls have the same underlying stock and the same expiration date. A bull call spread is established for a net debit (or net cost) and profits as the underlying stock rises in price. Profit is limited if the stock price rises above the strike price of the short call, and potential loss is limited if the stock price falls below the strike price of the long call (lower strike).

Maximum profit

Potential profit is limited to the difference between the strike prices minus the net cost of the spread including commissions. In the example above, the difference between the strike prices is 5.00 (105.00 – 100.00 = 5.00), and the net cost of the spread is 1.80 (3.30 – 1.50 = 1.80). The maximum profit, therefore, is 3.20 (5.00 – 1.80 = 3.20) per share less commissions. This maximum profit is realized if the stock price is at or above the strike price of the short call at expiration. Short calls are generally assigned at expiration when the stock price is above the strike price. However, there is a possibility of early assignment. See below.

Maximum risk

The maximum risk is equal to the cost of the spread including commissions. A loss of this amount is realized if the position is held to expiration and both calls expire worthless. Both calls will expire worthless if the stock price at expiration is below the strike price of the long call (lower strike).

Breakeven stock price at expiration

Strike price of long call (lower strike) plus net premium paid

In this example: 100.00 + 1.80 = 101.80

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Profit/Loss diagram and table: bull call spread

Long 1 100 call at (3.30)
Short 1 105 call at 1.50
Net cost = (1.80)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Short 105 Call Profit/(Loss) at Expiration Bull Call Spread Profit/(Loss) at Expiration
108 +4.70 (1.50) +3.20
107 +3.70 (0.50) +3.20
106 +2.70 +0.50 +3.20
105 +1.70 +1.50 +3.20
104 +0.70 +1.50 +2.20
103 (3.30) +1.50 +1.20
102 (3.30) +1.50 +0.20
101 (3.30) +1.50 (0.80)
100 (3.30) +1.50 (1.80)
99 (3.30) +1.50 (1.80)
98 (3.30) +1.50 (1.80)
97 (3.30) +1.50 (1.80)
96 (3.30) +1.50 (1.80)

Appropriate market forecast

A bull call spread performs best when the price of the underlying stock rises above the strike price of the short call at expiration. Therefore, the ideal forecast is “modestly bullish.”

Strategy discussion

Bull call spreads have limited profit potential, but they cost less than buying only the lower strike call. Since most stock price changes are “small,” bull call spreads, in theory, have a greater chance of making a larger percentage profit than buying only the lower strike call. In practice, however, choosing a bull call spread instead of buying only the lower strike call is a subjective decision. Bull call spreads benefit from two factors, a rising stock price and time decay of the short option. A bull call spread is the strategy of choice when the forecast is for a gradual price rise to the strike price of the short call.

Impact of stock price change

A bull call spread rises in price as the stock price rises and declines as the stock price falls. This means that the position has a “net positive delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bull call spread consists of one long call and one short call, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bull call spread consists of one long call and one short call, the price of a bull call spread changes very little when volatility changes. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since a bull call spread consists of one long call and one short call, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or below the strike price of the long call (lower strike price), then the price of the bull call spread decreases with passing of time (and loses money). This happens because the long call is closest to the money and decreases in value faster than the short call. However, if the stock price is “close to” or above the strike price of the short call (higher strike price), then the price of the bull call spread increases with passing time (and makes money). This happens because the short call is now closer to the money and decreases in value faster than the long call. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull call spread, because both the long call and the short call decay at approximately the same rate.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long call in a bull call spread has no risk of early assignment, the short call does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is above the strike price of the short call in a bull call spread (the higher strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by selling the long call to close and buying the short call to close. Alternatively, the short call can be purchased to close and the long call can be kept open.

If early assignment of a short call does occur, stock is sold. If no stock is owned to deliver, then a short stock position is created. If a short stock position is not wanted, it can be closed by either buying stock in the marketplace or by exercising the long call. Note, however, that whichever method is chosen, the date of the stock purchase will be one day later than the date of the stock sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price or above the higher strike price. If the stock price is at or below the lower strike price, then both calls in a bull call spread expire worthless and no stock position is created. If the stock price is above the lower strike price but not above the higher strike price, then the long call is exercised and a long stock position is created. If the stock price is above the higher strike price, then the long call is exercised and the short call is assigned. The result is that stock is purchased at the lower strike price and sold at the higher strike price and no stock position is created.

Other considerations

The “bull call spread” strategy has other names. It is also known as a “long call spread” and as a “debit call spread.” The term “bull” refers to the fact that the strategy profits with bullish, or rising, stock prices. The term “long” refers to the fact that this strategy is “long the market,” which is another way of saying that it profits from rising prices. Finally, the term “debit” refers to the fact that the strategy is created for a net cost, or net debit.

Option Spreads

An option spread is created when one option is purchased and another is sold simultaneously. The two options typically have different strike prices or expiration dates, and the trader who placed the spread order only has to come up with the cash difference between the option being bought and the one being sold. An option spread generally has a lower degree of risk and maximum profit potential than the outright purchase or sale of a single option.

Credit Spreads

Debit Spreads

Vertical Spreads

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