Spreads and Combinations
Spreads involve simultaneously buying and selling options of the same type (both calls or both puts) on the same underlying security. These strategies limit both risk and reward.
Spread Basics
Debit Spread vs. Credit Spread
| Type | Net Premium | Market Expectation | Max Gain |
|---|---|---|---|
| Debit Spread | Pay premium | Expect significant move | Difference in strikes minus net premium |
| Credit Spread | Receive premium | Expect limited move | Net premium received |
Memory Tip: "Buy low, sell high" applies to strikes too. In a debit spread, you're buying the more expensive option.
Bull Call Spread (Debit Spread)
Buy a call at a lower strike, sell a call at a higher strike. Used when moderately bullish.
Example
- Buy 1 XYZ 50 Call @ $5
- Sell 1 XYZ 55 Call @ $2
- Net Debit = $3
| Calculation | Formula | Result |
|---|---|---|
| Maximum Gain | (Higher Strike - Lower Strike) - Net Premium | ($55 - $50) - $3 = $200 |
| Maximum Loss | Net Premium Paid | $3 × 100 = $300 |
| Breakeven | Lower Strike + Net Premium | $50 + $3 = $53 |
Bear Put Spread (Debit Spread)
Buy a put at a higher strike, sell a put at a lower strike. Used when moderately bearish.
Example
- Buy 1 XYZ 55 Put @ $5
- Sell 1 XYZ 50 Put @ $2
- Net Debit = $3
| Calculation | Formula | Result |
|---|---|---|
| Maximum Gain | (Higher Strike - Lower Strike) - Net Premium | ($55 - $50) - $3 = $200 |
| Maximum Loss | Net Premium Paid | $3 × 100 = $300 |
| Breakeven | Higher Strike - Net Premium | $55 - $3 = $52 |
Credit Spreads
Bull Put Spread (Credit Spread)
Sell a put at a higher strike, buy a put at a lower strike. Used when moderately bullish.
- Receive net premium
- Maximum gain = Premium received
- Maximum loss = Difference in strikes - Premium received
Bear Call Spread (Credit Spread)
Sell a call at a lower strike, buy a call at a higher strike. Used when moderately bearish.
- Receive net premium
- Maximum gain = Premium received
- Maximum loss = Difference in strikes - Premium received
Straddles
A straddle involves buying or selling both a call and a put with the same strike price and expiration.
Long Straddle
- Buy 1 XYZ 50 Call @ $3
- Buy 1 XYZ 50 Put @ $2
- Total Premium = $5
| Aspect | Details |
|---|---|
| Market View | Expect HIGH volatility (big move either direction) |
| Maximum Gain | Unlimited (if stock rises) or Strike - Premium (if stock falls) |
| Maximum Loss | Total premium paid ($500) |
| Breakeven Points | $50 + $5 = $55 (upside) and $50 - $5 = $45 (downside) |
Short Straddle
- Sell 1 XYZ 50 Call @ $3
- Sell 1 XYZ 50 Put @ $2
- Total Premium = $5
| Aspect | Details |
|---|---|
| Market View | Expect LOW volatility (stock stays near strike) |
| Maximum Gain | Total premium received ($500) |
| Maximum Loss | Unlimited |
| Breakeven Points | $50 + $5 = $55 and $50 - $5 = $45 |
Exam Alert: Long straddles profit from volatility. Short straddles profit from stability. The exam often tests which strategy fits which market outlook.
Strangles
A strangle is similar to a straddle but uses different strike prices (usually both out-of-the-money).
Long Strangle
- Buy 1 XYZ 55 Call @ $2
- Buy 1 XYZ 45 Put @ $1
- Total Premium = $3
| Aspect | Details |
|---|---|
| Market View | Expect HIGH volatility |
| Maximum Loss | Total premium paid ($300) |
| Lower Cost | Cheaper than straddle because both options are OTM |
| Breakeven Points | $55 + $3 = $58 and $45 - $3 = $42 |
Spread Categories Summary
| Spread Type | Options | Net Position | Market View |
|---|---|---|---|
| Vertical | Same expiration, different strikes | Most common | Directional |
| Horizontal (Calendar) | Same strike, different expirations | Time decay play | Neutral |
| Diagonal | Different strikes AND expirations | Complex | Various |
Quick Reference: Which Strategy for Which View?
| Market Outlook | Best Strategy |
|---|---|
| Strongly Bullish | Long Call or Bull Call Spread |
| Moderately Bullish | Bull Call Spread or Bull Put Spread |
| Neutral (Low Volatility) | Short Straddle or Short Strangle |
| Neutral (High Volatility Expected) | Long Straddle or Long Strangle |
| Moderately Bearish | Bear Put Spread or Bear Call Spread |
| Strongly Bearish | Long Put or Bear Put Spread |
Important: Spreads limit both profit potential and loss. They're often preferred by conservative traders who want defined risk.
An investor executes a bull call spread by buying an ABC 40 Call for $5 and selling an ABC 45 Call for $2. What is the maximum gain?
An investor buys a straddle with XYZ 50 Call @ $4 and XYZ 50 Put @ $3. What are the breakeven points?
Which strategy profits most from a stock remaining stable (low volatility)?
8.5 Index and Non-Equity Options
Continue learning