In this article, we will examine the various terminologies and categories of option spreads which are frequently used by option traders. You should be well acquainted with:
- General overview of option spreads
- The fact the option spreads are less risky than naked positions
- Call Spreads and Put spreads
- Diagonal spreads
- Horizontal spreads
- Vertical spreads
- Credit spreads vs Debit spreads
- Bull spreads
- Bear spreads
General overview of option spreads
Option spreads involves the buying and selling of an equal number option contracts of the same class and on the same underlying security but these option contracts may have different strike prices and/or different expiration dates. Spreads are known to limit a trades profit potential and limit the potential loss as well. This makes spreads a less risky strategy than selling naked put options or naked call options.
Options spreads are less risky than Naked put and call writing
Since naked call and put writing are riskier strategies than option spreads, brokers may impose more stringent margin requirement criteria for naked selling. For trading accounts with option spreads strategies, margin requirements would tend to be less strict and these accounts have more leeway to utilise the funds that have been deposited with the broker.
|Option spreads||Less risky than naked calls and naked puts|
|Naked Puts||More risky than option spreads|
|Naked Calls||More risky than option spreads|
A bull call spread is an example of an option spread. As you can see, the bull call spread’s maximum potential loss is limited but a naked call’s maximum potentials loss is unlimited.
Call Spreads , Put Spreads, Diagonal Spreads, Vertical Spreads, Horizontal Spreads
A spread that is formed with call options are called call spreads. A spread that is formed with put options are called put spreads. An example of a call spread is a bull call spread and an example of a put spread is a bull put spread.
Diagonal spreads are formed using options of the same underlying security but with different strike prices and expiry dates.
Horizontal spreads are formed using options of the same underlying security with the same strike prices but with different expiration dates. Horizontal spreads are also known as calendar spreads.
Vertical spreads are created when an equal number of option contracts are bought and sold simultaneously from the same class of options on the same underlying security. These options have the same expiration date but different strike prices.
An example of a vertical spread is a bull call spread(Executing A Bull call spread) where a lower strike call is purchased with the simultaneous sale of a higher strike call.
Credit spread or debit spreads
The term credit spreads implies that a credit is received when the trade is executed. This is because the option premiums of the options which are sold are greater than the option premiums used to buy options. Hence, the trader receives a credit into his account.
The term debit spreads implies that a trading account is debited when the trade is executed. This is because the option premiums of the options which are sold are less than the option premiums used to buy options. Hence a deduction is made to the trader’s account to effect the trade. An example of a debt spread is a bull call spread.
Bull spreads are vertical spreads that involve the buying and selling of options within the same class on the underlying security, but with different strike prices. When a trader executes a bull spread, he is predicting that the price of the underlying security goes up. Bull spreads can be created using call options or put options.
Bear spreads are vertical spreads that involve the buying and selling of options within the same class on the underlying security, but with different strike prices. A trader in this case, is predicting that the underlying security is bearish. Higher strike price options are purchased while lower strike price options are sold. Bear spreads can be created using either put or call options.