Options spread
Encyclopedia
Options spreads are the basic building blocks of many options trading strategies
. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike price
s or expiration dates. Options Spreads are limited risk and limited profit strategy.
The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread
. They are grouped by the relationships between the strike price and expiration dates of the options involved.
Vertical spreads
, or money spreads, are spreads involving options of the same underlying security, same expiration month, but at different strike prices.
Horizontal, calendar spread
s, or time spreads are created using options of the same underlying security, same strike prices but with different expiration dates.
Diagonal spreads are constructed using options of the same underlying security but different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.
can be referred to as a call spread, while a put spread is constructed using put option
s.
while those entered on a credit are known as credit spreads.
. When more options are purchased than written, it is a backspread
.
can be broken down into a combination of a bull put spread and a bear call spread.
consists of a bull call spread and a bear put spread. The calls and puts have the same expiration
date. The resulting portfolio is delta neutral
. For example, a 40-50 January 2010 box consists of:
A box spread position has a constant payoff at exercise equal to the difference in strike values. Thus, the 40-50 box example above is worth 10 at exercise. For this reason, a box is sometimes considered a "pure interest rate play" because buying one basically constitutes lending some money to the counterparty until exercise.
The net volatility
of an option spread trade is the volatility level such that the theoretical value of the spread trade is equal to the spread's market price. In practice, it can be considered the implied volatility
of the option spread.
References
Options strategies
Options strategies can favor movements in the underlying that are bullish, bearish or neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility...
. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
s or expiration dates. Options Spreads are limited risk and limited profit strategy.
The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread
Diagonal spread
In Finance, A diagonal spread is established by simultaneously entering into a long and short position in two options of the same type but with different strike prices and expiration dates.-External links:...
. They are grouped by the relationships between the strike price and expiration dates of the options involved.
Vertical spreads
Vertical spread
In options trading, a vertical spread is an options strategy involving buying and selling of multiple options of the same underlying security, same expiration date, but at different strike prices...
, or money spreads, are spreads involving options of the same underlying security, same expiration month, but at different strike prices.
Horizontal, calendar spread
Calendar spread
In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date...
s, or time spreads are created using options of the same underlying security, same strike prices but with different expiration dates.
Diagonal spreads are constructed using options of the same underlying security but different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.
Call and put spreads
Any spread that is constructed using callsCall option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
can be referred to as a call spread, while a put spread is constructed using put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
s.
Bull and bear spreads
If a spread is designed to profit from a rise in the price of the underlying security, it is a bull spread. A bear spread is a spread where favorable outcome is obtained when the price of the underlying security goes down.Credit and debit spreads
If the premiums of the options sold is higher than the premiums of the options purchased, then a net credit is received when entering the spread. If the opposite is true, then a debit is taken. Spreads that are entered on a debit are known as debit spreadsDebit Spread
In finance, a debit spread, AKA net debit spread, results when an investor simultaneously buys an option with a higher premium and sells an option with a lower premium...
while those entered on a credit are known as credit spreads.
Ratio spreads and backspreads
There are also spreads in which unequal number of options are simultaneously purchased and written. When more options are written than purchased, it is a ratio spreadRatio spread
Ratio-spread is a strategy in options trading that involves buying some number of options and selling a larger number of other options of the same underlying market and the same expiration date, but of a different strike price....
. When more options are purchased than written, it is a backspread
Backspread
The backspread is the converse strategy to the ratio spread and is also known as reverse ratio spread. Using calls, a bullish strategy known as the call backspread can be constructed and with puts, a strategy known as the put backspread can be constructed....
.
Spread combinations
Many options strategies are built around spreads and combinations of spreads. For example, a bull put spread is basically a bull spread that is also a credit spread while the iron butterflyIron Butterfly Spread
In finance an iron butterfly is the name of an advanced, neutral-outlook, options trading strategy that involves buying and holding four different options at three different strike prices. It is a limited-risk, limited-profit trading strategy that is structured for a larger probability of earning...
can be broken down into a combination of a bull put spread and a bear call spread.
Box spread
A box spreadBox spread
In options trading, a box spread is a combination of positions that has a certain payoff, considered to be simply "delta neutral interest rate position"...
consists of a bull call spread and a bear put spread. The calls and puts have the same expiration
Expiration
Expiration is an independent feature film written, directed and starring Gavin Heffernan. It was the winner of the Grand Jury Prize and Best Film at the Canadian Filmmakers' Festival....
date. The resulting portfolio is delta neutral
Delta neutral
In finance, delta neutral describes a portfolio of related financial securities, in which the portfolio value remains unchanged due to small changes in the value of the underlying security...
. For example, a 40-50 January 2010 box consists of:
- Long a January 2010 40-strike call
- Short a January 2010 50-strike call
- Long a January 2010 50-strike put
- Short a January 2010 40-strike put
A box spread position has a constant payoff at exercise equal to the difference in strike values. Thus, the 40-50 box example above is worth 10 at exercise. For this reason, a box is sometimes considered a "pure interest rate play" because buying one basically constitutes lending some money to the counterparty until exercise.
Net volatility
- For the main article, see net volatilityNet volatilityNet volatility refers to the volatility implied by the price of an option spread trade involving two or more options. Essentially, it is the volatility at which the theoretical value of the spread trade matches the price quoted in the market, or, in other words, the implied volatility of the...
The net volatility
Net volatility
Net volatility refers to the volatility implied by the price of an option spread trade involving two or more options. Essentially, it is the volatility at which the theoretical value of the spread trade matches the price quoted in the market, or, in other words, the implied volatility of the...
of an option spread trade is the volatility level such that the theoretical value of the spread trade is equal to the spread's market price. In practice, it can be considered the implied volatility
Implied volatility
In financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...
of the option spread.
References
External links
- Option Strategies - An illustrated introduction to option spreads.
- Futures Spread Trading - Trading Options on futures.
- Option Spread Trading