Introduction
An
option spread is a combination of
options. As such, it is an example of an
option strategy. In this writeup, we will see two examples of an
option spread: the regular spread, and the
calendar spread. This writeup assumes the reader is familiar with what an
option is.
The regular option spread
A regular option spread consists of two options, two
calls or two
puts. These two
options have the same
underlying, and time to
expiry, but different
strikes. Here, one is
long one of the options, and
short the other.
As an example, consider a
call spread. If one is
long the option with the lower strike, and
short the option with the higher strike, the following payoff at expiry is found:
- If the underlying expires below the lowest strike, both options are worthless. The spread expires worthless.
- If the underlying is above the lowest strike, but below the highest strike, the option with the lowest strike is in the money, but the option with the highest strike is not. As such, the payoff is 1 for each 1 the underlying is above the lowest strike
- If the underlying is above the highest strike, the second option is also in the money. As such, the payoff is equal to the difference in the lowest and the highest strike.
The payoff of this
spread is aways positive. As such, one would always have to pay for this. However, it is obviously cheaper than the normal long call. As such, it can be used to get the normal
bullish exposure, but cheaper.
Selling a call spread is also possible. In this case, the seller hopes the underlying will drop. When it does, the call spread expires worthlessly, and the seller gets to keep the
premium. It is not nearly as risky as selling a
naked call, as the potential loss on a
naked call is
unlimited. As such,
A put spread is in many ways the opposite of the call spread. For puts, a put with the highest strike has the highest price. This means that:
- If the underlying is below the lowest strike at expiry, both puts are in the money. As such, the total payoff is equal to the difference between the strikes.
- If the underlying is above the lowest strike, but below the highest strike, the option with the highest strike strike is in the money, but the option with the lowest strike is not. As such, the payoff is 1 for each 1 the underlying is below the highest strike
- If the underlying is above the highest strike, both options are worthless.
If one is long the high strike, the payoff is always zero or positive. As such, one needs to pay for this. So, being long a put spread is being
bearish. Selling the put spread, hoping that it expires worthlessly and pocketing the
premium is bullish.
The calendar spread
A
calendar spread consists of two options with the same
strike and
underlying, but with different times to expiry. For both calls and puts, a longer-dated option almost always is more expensive than a shorter-dated option. As such, if one is long the longer-dated option, one is long the calendar spread, and if one is short the longer-dated option, one is short the calendar spread.
The idea behind a calendar spread is that the underlying will rise (call) or fall (put), but it won't do so for a while. As such, one sells the shorter-dated option, to be able to buy the longer-dated option more cheaply. This is a complex trade; it requires one to be right on both
timing and
direction. However, if one is right, the potential payoff can be very high.
Unlike the regular spread, the calendar spread does not have a limited gain and limited loss. If, for instance, one is long a call calendar spread, one could lose money if the underlying first rises sharply, losing money on the
short call, and then drops, making the long call worthless. This can be prevented by selling the longer-dated call at the expiry of the shorter-dated call.
Conclusion
An
option spread is an
option strategy that consists of a a long and a short put or call on the same underlying. In case of a normal spread, these have the same expiry, but different strikes; in case of a
calendar spread, the strikes are the same, but the expirations differ. The normal option spread is a common and relatively
safe way of having a
leveraged long or short position in an underlying, with limited risk. The
calendar spread is more risky and more difficult, being a play on both
time and
direction.