A spread is the simultaneous buying of an option and selling another option on the same stock, with different expiration months and/or strike prices. Spreads are often applied when price movements are expected to remain limited.
Types of spreads
There are 3 types:
- spreads made up of options with different strike prices, the so-called price spreads or vertical spreads.
- spreads made up of options with different expiry months, the so-called time spreads or horizontal spreads.
- spreads made up of options with both different strike prices and different expiry months, the so-called time-price spreads or diagonal spreads.
Ad.1. Buy a 30-35 price spread on a stock by buying a call 30 for a premium of $3 and selling a call 35 for a premium of $1. On balance you pay €2 for this. What are the options now:
- the share price ends on the expiry date above the strike price of the written call of 35. Both options are now ITM (in the money) and you earn the difference in the strike prices minus the investment, i.e. 5.00 minus 2.00 = 3.00.
- the share price ends on the expiration date below the strike price of the purchased call of 30. Both options are now OTM (out of the money) and expire worthless. You lose the entire investment.
- the share price ends on the expiration date between the exercise prices of both options. You now earn/lose the difference between the strike price of the purchased call and the stock price minus the $2 investment.
This spread is aimed at a (slight) increase. Likewise, with puts the opposite can be taken when a decline is expected. In the first case (calls) one also speaks of a bull spread, in the second case (puts) of a bear spread.
Ad.2. Buying an October 50 call for 5.50 and simultaneously selling a May 50 call for 4.00. To take this position an investment of €150 is required.
- Suppose the rate is at 47.50 and remains there, then you collect the premium for the May series on the expiry date and that of October has decreased in value because the expiry date is approaching. Yet it still has value. Suppose that value is still 3.50 on the expiry date of the May series and the options are sold, then the profit is 350 minus 150 = 200.
- If the price falls (significantly), the May call will expire worthless, but the remaining premium from the October call will probably be insufficient to cover the investment. Of course, you can always keep the call if you expect a rise again.
- However, with a (significant) increase, the premiums of the shares will become increasingly equal, so that little of the profit remains. At a price of 60 on the expiry date, the May call is worth exactly 10 and the October call, for example, is approximately 12. In this case there is no more than €50 left.
Time price spread
Ad.3. Buying a January 170 call for $10 and selling an October 180 call for $5 at the same time. You then invest €5 per contract. Suppose the rate is 170. The ultimate goal is to acquire the January 170 call for a premium of 5. This happens if the 180 call expires worthless on the expiry date, so the price is lower than 180. The maximum loss in this construction is 300 and the maximum profit 700,-.