An option spread is any combination of long and short options for the same underlying asset, but with different stike prices and sometimes even different expiration dates between the long and short options.
Each option within an option spread is typically referred to as a leg of the spread. So an option spread would have at least two legs.
Credit and Debit Option Spreads
There are several ways to categorize option spreads. Let’s start with the simpliest terminology first, which are credit and debit spreads. The focus here between these terms is the price of a spread, which can be easily calculated by summing up the prices of each option within the spread.
If the price of an option spread is negative, this is called a debit spread, which means means that you would have to pay in order to open a position. If the price of an option spread is postive, this is called a credit spread, which means you receive money for opening a position.
Credit spread = receive payment for opening, requires payment to close
Debit spread = requires payment to open, receive payment for closing
For example, let’s say you buy to open a call option for $20 and sell to open a separate call option for $5. This results in a debit of $20 (you paid $20) and a credit of $5 (you received $5). The sum equals to a debit of $15. So this would be a debit spread that costs $15 to open.
Call and Put Option Spreads
An option spread that only consists of call options is called a call spread. These can come in debit or credit formats, which are also called bull and bear spreads, respectively.
On the other hand, an option spread that only consists of put options is called a put spread. Since puts are the opposite of calls, the bull and bear terminology are reversed. So a credit put spread would be a bull put spread and a debit put spread would be a bear put spread.
Vertical, Horizontal, and Diagonal Spreads
For the next set of option spreads, we’ll assume that the number of long options equal the number of short options and we’ll take a look at the selection of strike prices and expiration dates. This way of categorizing spreads include vertical spreads, horizontal spreads, and diagonal spreads.
Vertical spreads are option spreads that have the same expiration date, but have different strike prices between the long and short options.
Vertical spread = different strike prices, same expiration date
Horizontal spreads, which are also called calendar spreads, are option spreads that have the same strike price, but different expiration dates between the long and short options. The reason why this is called a calendar spread is because it has more of a focus on the time factor due to the different expiration dates.
Horizontal spread = different expiration dates, same strike prices
Lastly, diagonal spreads are those that are constructed with options that are different in both strike prices and expiration dates.
Diagonal spread = different strike prices and differnet expiration dates
What happens if the number of long options don’t match the number of short options in a spread? Well, you’ll end up with an uneven spread. When there are more short options then long options, the spread is called a ratio spread and when there are more long options than short options, the spread is called a back spread.
Ratio spread = # short options > # long options
Back spread = # long options > # short options
Directional and Non-Directional Spreads
So far, all of the above spreads, except the calendar spread, can also be considered as directional spreads.
A directional spread is one that is opened on the premise that the underlying asset will move in one particular direction, whether that be up or down. For example, a bull call spread is a directional spread that achieves maximum profit when the price of the underlying asset rises. So the desired direction is upwards.
Option spreads can also be constructed into particular combinations that have optimum outcomes that don’t rely on the underlying asset moving in a particular direction. In other words, a non-directional spread is one that is direction agnostic. It does not depend on the underlying asset moving in a single direction.
Some non-directional spreads that work well when the price of an underlying asset does not change much and stays within a small range include calendar spreads, iron condors, butterfly spreads, etc. Non-direction spreads that work best with movement of the underlying asset’s price include straddles, strangles, reverse iron condors, etc.
Straddles, Strangles, and Butterfly Spreads
A straddle is a combination of an equal number of long calls and long puts with the same expiration date and the same strike price.
Straddle = long call, long put, same strike price, same expiration date
Since this consists of both a long call and a long put, the result is a setup where you have a chance to profit regardless of which direction the underlying asset moves (either up or down). A scenario where one might open a straddle is when one expects an underlying asset to change in price, but isn’t sure which direction the price of the asset will move. The caveat is that the price of the asset needs to move enough so that the loss witin the option in the opposite direction can be overcome.
For example, let’s say you open a straddle and the price of the underlying asset rises. As a result of the rise in price of the underlying asset, the long call also rises in value, but the long put falls in value. In order to actually make a profit on the straddle, you would need the profit from the long call ot be larger than the loss on the long put. The farther the price of the underlying asset moves away from the center of the straddle, the more likely the profit on one side will be larger than the loss on the other side and result in an overall profit on the straddle.
Variations of the straddle include strangles and butterfly spreads.
A strangle is similar to a straddle in that it consists of an equal number of long calls and long puts with the same expiration dates, but the strike prices will be different with the long call having a higher strike price than the long put.
A butterfly spread is the opposite of a straddle with an equal number of short calls and short puts with the same expiration date and strike prices. The profit and loss outcomes are reversed as a result. Butterfly spreads are opened on the premise that the price of an underlying asset will not change much over a period of time.
An iron condor consists of the combination of a bear call spread (in other words, a credit call spread) and a bull put spread (in other words, a credit put spread). With the bear call spread, you want the price of the underlying asset to fall while with the bull put spread, you want the price of the underlying asset to rise. These might seem contradictory at first glance, but it works out because the point of an iron condor setup is to wager that the price of the underlying asset stays within a narrow range between the two spreads.
Both spreads are opened for a credit and thus an iron condor is opened for a credit. In other words, you receive money for opening an iron condor.
Ideally, the price of the underlying asset will remain between the two spreads until all options in the iron condor expire worthless so that you can keep the full credit from when you opened the two spreads of the iron condor.
Remember, options will typically lose value as the expiration date approches. An iron condor is opened via a credit so it has a positive value when opened. As time progresses towards the expiration date, assuming nothing else has changed, the value of the iron condor will fall. This then makes it possible for you to close the iron condor by paying a debit which is smaller than the initial credit you received.
An iron condor can also be reversed and is simply called a reverse iron condor. It’s usage is similar to that of a strangle with the only difference that the profit is capped. Similar to strangles, a reversed iron condor is opened on the premise that the underlying asset will undergo a large change in price whether that be up or down.
Option spreads can also be further combined with each other. One such combination is called the box spread, which involves a bull call spread and a bear put spread. The calls and puts all have the same expiration date. The result of combining these two spreads is one that is delta neutral that can theoretically result in a profit no matter what happens to the price of the underlying asset. Even though this can theoretically work, in practice, there are many pitfalls involved with the box spread.