Option Spread

An option spread is a position made up of two or more options on the same underlying, some bought and some sold, that differ in strike price, expiry date or both. The options are chosen so that the gains on some offset the losses on others, which reshapes the risk and reward compared with holding a single option. Most spreads limit the maximum loss, the maximum gain or both.

Spreads are the basic building blocks of options strategy. They allow a trader to express a specific view, such as a moderate rise, a fall in volatility or a quiet market, at lower cost or with less risk than an outright call or put. They should not be confused with the bid-ask spread on a quote or with spread trading between related futures or securities.

• Vertical spreads. The options have the same expiry and different strikes. A bull spread profits from a rise and a bear spread from a fall. Each can be built with calls or with puts.
• Horizontal spreads. The options have the same strike and different expiries. The usual name is calendar spread.
• Diagonal spreads. The options differ in both strike and expiry.
• Multi-leg spreads. Three or four options are combined into shapes such as the butterfly spread, the condor spread and the iron condor, which profit when the underlying stays within a range.
• Ratio spreads. Unequal numbers of options are bought and sold, for example one bought and two sold.

A second distinction is between debit and credit spreads. In a debit spread the options bought cost more than those sold, so the trader pays a net premium, which is the most that can be lost. In a credit spread the trader receives a net premium, which is the most that can be gained.

A bull call spread buys a call at a lower strike $K_1$ and sells a call at a higher strike $K_2$ with the same expiry. Its maximum loss is:

Its maximum profit is:

Its break-even price at expiry is:

Suppose a share trades at 102. A trader buys the 100 call for 5 and sells the 110 call for 2, a net debit of 3. If the share ends below 100, both calls expire worthless and the loss is 3. If it ends above 110, the spread is worth 10 and the profit is $10 - 3 = 7$. The break-even price is $100 + 3 = 103$. Buying the 100 call alone would have cost 5 and broken even at 105, but would have kept the gains above 110 that the spread gives up.

The sold option pays for part of the bought one. This lowers the cost and the break-even point, at the price of capping the profit. A spread also reduces exposure to the factors that affect all options on the underlying. Because one leg is long and the other short, their sensitivities to implied volatility and to time partly cancel, so the position's vega and theta are smaller than those of a single option. A trader who believes implied volatility is high can take a directional view through a spread without paying heavily for volatility.

Credit spreads are used to collect premium with a defined worst case. Selling a put and buying a lower-strike put, for example, earns the net credit if the underlying stays above the higher strike, and the long put limits the loss if it falls. Calendar spreads take a view on time and on the term structure of volatility: the near-dated option sold decays faster than the longer-dated option bought. Spreads between strikes are also the natural way to trade the volatility skew, the difference in implied volatility across strikes.

Exchanges and brokers recognise that a spread carries less risk than its short leg alone, so the margin required is normally based on the spread's maximum loss, not on the uncovered option. This makes defined-risk spreads accessible to accounts that would not be permitted to write options outright.

Spreads can be entered as a single order at a net price, which the exchange executes as a package, so the trader does not risk filling one leg and missing the other. Each leg still has its own bid-ask spread and commission, and for spreads with a small net premium these costs take a significant share of the potential profit.

The limited loss of a spread is certain only at expiry and only if both legs are held to that point. With American-style options, the short leg can be assigned early, most often when it is deep in the money or just before a dividend, leaving the trader with a share position and a remaining long option. If the underlying finishes between the two strikes at expiry, one leg is exercised and the other is not, which can also leave an unexpected position. Before expiry the value of a spread responds only gradually to a favourable move, because the two legs offset each other, so a correct view may take until close to expiry to pay off in full. The pay-out at expiry of each leg is described under option payoff.