Option spread definition

What is an options spread?

An options spread is an options trading strategy in which a trader will buy and sell multiple options of the same type – either call or put – with the same underlying asset. These options are similar, but typically vary in terms of strike price, expiry date, or both.

What are the types of options spread strategies?

There are three main types of options spread strategy: vertical, horizontal and diagonal.

A vertical spread strategy – sometimes known as a money spread – uses two options with identical expiry dates but different strike prices. A vertical spread strategy enables traders to limit their downside risk, but in doing so, they also cap their upside potential. This is explained in the example below.

A horizontal spread strategy – also called a calendar spread – uses long and short options with identical strike prices but different expiry dates. The primary aim of a calendar spread is to profit from the effects of time decay on two different expiry options. Time decay – or theta – is a measure of how much an option’s price declines over time.

This is because options that are nearing their expiry date are more susceptible to time decay than longer-term options. As a result, in a horizontal spread strategy a trader can use a long-term option to offset any losses incurred if a short-term option is looking likely to expire worthless, and potentially still profit from the longer-term option.

A diagonal spread strategy involves simultaneously entering into long and short positions with two options of the same type, but with different strike prices and expiries. Diagonal spreads make use of time decay like a horizontal spread, but they also benefit from any movements in an option’s price for every point of movement in the underlying market – known as delta.

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Options spread example

Let’s look at a bullish vertical spread, which you’d use if you thought a market might rise, but wanted to limit your downside if it didn’t. In this scenario, a trader would first buy a call option with a given strike, but also sell another call with a higher strike. Both options would share the same expiry.

Let’s assume that the current price of a stock was 140, and you felt it could rise to 150. As a result, you might buy a call with a strike of 135 for a £9.30 premium (which you pay), and sell a call with a strike of 150 for a £2.50 premium (which you receive).

Your aggregate premium to open these options (and your maximum possible loss) is £6.80 (£9.30 paid minus £2.50 received). The time to expiry for both options is 45 days, and the spread on this strategy is the difference between the two strikes – 15 (150 minus 135).

In a profit scenario, the market moves to or above 150 at expiry. You sell the bought 135 call at a profit that always exceeds, but is limited by, your loss on the sold 150 call. Your maximum profit is calculated by subtracting the aggregate premium (6.80) from the spread width (15), which makes your maximum profit £8.20.

In a loss scenario, the market moves below 135 at expiry. Both options expire worthless, but you gained the £2.50 at which you sold the 150 call – resulting in a smaller loss than if you’d only bought the 135 call. Your maximum loss is simply the premium you paid (9.30), minus the premium you received for selling the 150 call (2.50) which equals a maximum loss of £6.80.

It is worth noting, that the sum of the maximum loss and profit for the strategy is equal to the spread (6.80 + 8.20 = 15).