All about Spreads!
When trading or investing in options, there are several option spread strategies that one could employ—a spread being the purchase and sale of different options on the same underlying as a package.
A credit spread involves selling, or writing, a high-premium option and simultaneously buying a lower premium option. The premium received from the written option is greater than the premium paid for the long option, resulting in a premium credited into the trader or investor's account when the position is opened. When traders or investors use a credit spread strategy, the maximum profit they receive is the net premium. The credit spread results in a profit when the options' spreads narrow.
For example, a trader implements a credit spread strategy by writing one March call option with a strike price of $350 for $7 and simultaneously buying one March call option at $500 for $3. Since the usual multiplier on an equity option is 100, the net premium received is $400 for the trade. Furthermore, the trader will profit if the spread strategy narrows.
Conversely, a debit spread—most often used by beginners to options strategies—involves buying an option with a higher premium and simultaneously selling an option with a lower premium, where the premium paid for the long option of the spread is more than the premium received from the written option. Unlike a credit spread, a debit spread results in a premium debited, or paid, from the trader's or investor's account when the position is opened. Debit spreads are primarily used to offset the costs associated with owning long options positions.
Call Spreads
Bear Call Spreads (Payment of option bought < Premium from option written):
EXAMPLE
* Short 1 XYZ 100 call (OTM)
* Long 1 XYZ 105 call (OTM)
A bear call spread, or a bear call credit spread, is a type of options strategy used when an options trader expects a decline in the price of the underlying spread. A bear call spread is achieved by purchasing call options at a specific strike price while also selling the same number of calls with the same expiration date, but at a lower strike price. The maximum profit to be gained using this strategy is equal to the credit received when initiating the trade.
The main advantage of a bear call spread is that the net risk of the trade is reduced. Purchasing the call option with the higher strike price helps offset the risk of selling the call option with the lower strike price.
Bull Call Spreads (Payment of option bought > Premium from option written):
EXAMPLE
* Short 1 XYZ 100 call (OTM)
* Long 1 XYZ 105 call (OTM)
A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains. Commodities, bonds, stocks, currencies, and other assets form the underlying holdings for call options.
The losses and gains from the bull call spread are limited due to the lower and upper strike prices. If at expiry, the stock price declines below the lower strike price—the first, purchased call option—the investor does not exercise the option. The option strategy expires worthlessly, and the investor loses the net premium paid at the onset. If they exercise the option, they would have to pay more—the selected strike price—for an asset that is currently trading for less.
Put Spreads
Bear Put Spreads (Payment of option bought > Premium from option written):
EXAMPLE
* Short 1 XYZ 100 put (OTM)
* Long 1 XYZ 95 put (OTM)
A bear put spread is a type of vertical spread. It consists of buying one put in hopes of profiting from a decline in the underlying stock, and writing another put with the same expiration, but with a lower strike price, as a way to offset some of the cost. Because of the way the strike prices are selected, this strategy requires a net cash outlay (net debit) at the outset.
Given that the stock price slides down closer to the lower strike price, the bear put spread functions as long put; in contrast to a plain long put, however, the possibility of greater profits stops at the strike price of put sold (the lower strike option). This is part of the tradeoff; the short put premium mitigates the cost of the strategy but also sets a ceiling on the profits.
Bull Put Spreads (Payment of option bought < Premium from option written):
EXAMPLE
* Short 1 XYZ 100 put (OTM)
* Long 1 XYZ 95 put (OTM)
A bull put spread involves being short a put option and long another put option with the same expiration but with a lower strike. The short put generates income, whereas the long put's main purpose is to offset assignment risk and protect the investor in case of a sharp move downward. Because of the relationship between the two strike prices, the investor will always receive a premium (credit) when initiating this position.
This strategy entails precisely limited risk and reward potential. The most this spread can earn is the net premium received at the outset, which is likeliest if the stock price stays steady or rises.