📊 Introduction to spreads & Naming spreads
Investors use spreads for many reasons. Often, the type of spread reflects a bullish or bearish market view. You’ll see the intent behind these strategies more clearly in the next few chapters.
There are two broad categories of spreads:
• Call spreads
• Put spreads
Let’s look at an example of each.
👉 An example of a call spread:
Long 1 ABC Jan 60 call
Short 1 ABC Jan 70 call
When an investor is long one call and short another call at the same time, they’ve created a call spread. The two options can have different strike prices, different expirations, or both. As long as you’re long a call and short a call simultaneously, it’s a call spread.
👉 Next, an example of a put spread:
Long 1 ABC Mar 40 put
Short 1 ABC Jun 40 put
When an investor is long one put and short another put at the same time, they’ve created a put spread. Again, the two options can have different strike prices, different expirations, or both. As long as you’re long a put and short a put simultaneously, it’s a put spread.
📊 The differences in strike prices and/or expirations across the two legs determine how a spread is classified. There are three spread classifications:
• Vertical (price) spreads
• Horizontal (calendar/time spreads)
• Diagonal spreads
1️⃣ First, let’s start with a vertical (price) spread:
Long 1 ABC Jan 60 call
Short 1 ABC Jan 70 call
A vertical spread exists when the two contracts have different strike prices but the same expiration. Here, the strike prices differ ($60 and $70), but both options expire in January.
Vertical spreads are also called price spreads. That name fits because the “spread” (difference) is in the strike prices.
2️⃣ Next, let’s look at a horizontal (calendar/time) spread:
Long 1 ABC Mar 40 put
Short 1 ABC Jun 40 put
A horizontal spread exists when the two contracts have different expirations but the same strike price. Here, the expirations differ (March and June), but both options have the $40 strike.
Horizontal spreads are also known as time spreads or calendar spreads. Again, the “spread” (difference) is in the expirations.
If you’re wondering where the terms come from, vertical (up and down) and horizontal (side to side) relate to a standard price chart:
• The vertical axis shows price
• The horizontal axis shows time
3️⃣ Last, let’s look at a diagonal spread:
Long 1 ABC Sep 45 call
Short 1 ABC Nov 55 call
A diagonal spread exists when the two contracts have different expirations and different strike prices. Here, the expirations differ (September and November) and the strike prices differ ($45 and $55).
It is unlikely you’ll encounter any math-related test questions on diagonal spreads, but you may be asked to identify them.
📊 Key points
Call spreads
• Long call & short call
Put spreads
• Long put & short put
Vertical spread
• Different strikes, but the same expiration
• Also known as a price spread
Horizontal spread
• Different expirations, but same strike
• Also known as a calendar or time spread
Diagonal spread
• Different strike prices and expirations
📊 Naming spreads
A spread has two or more legs, but one option is always the dominant option. Every contract affects the strategy’s risk and return, but one leg matters most for identifying the spread. The key rule is simple:
• The dominant option is the one that names the spread.
You’ll see exactly why one option is dominant when you reach the math-based spread sections in the next two Topic.
📊 Complex spread strategies
Although most spreads involve two legs (e.g., one long call and one short call), more advanced spread strategies exist. For example, a butterfly spread involves three spreads and four options. For example:
Long 1 ABC Jan 30 call
Short 2 ABC Jan 40 calls
Long 1 ABC Jan 50 call
As the name suggests, this strategy has a solid “core” (the two short calls) with “wings” on either side (the long 30 call and the long 50 call). While it’s unlikely you’ll encounter difficult math-based questions on butterfly spreads, you may be asked to identify one.
📊 Leg (options)
A single option position
📊 Multi-leg strategy (options)
A strategy involving two or more option types
There are three specific ways to determine the dominant option within a spread:
• The option premiums
• The strike prices
• The expirations
Let’s go through each one.
1️⃣ The option premiums
The dominant leg within a spread is the most valuable contract. An option’s premium is its market value: the more valuable the contract, the higher the premium. So when premiums are given, the dominant leg is the option with the highest premium.
For example:
Long 1 ABC Jan 60 call @ $7
Short 1 ABC Jan 70 call @ $2
The long call has the higher premium, so it’s the dominant leg. Since the dominant leg names the spread, this spread has three synonymous names:
1. Long call spread
2. Bull call spread
3. Debit call spread
Each name points back to the dominant long call:
• It’s a long call spread because the long call is dominant.
• It’s a bull call spread because a long call is bullish.
• It’s a debit call spread because the long call costs more, creating a net debit (net purchase).
📊 Debit
Represents money paid to buy an option; associated with going long an option
📊 Credit
Represents money received to sell an option; associated with going short an option
👉 Let’s see if you can name a spread.
An investor goes long 1 BCD Feb 25 put at $4 and short 1 BCD Feb 40 put at $11. What are the three names associated with this spread?
Can you figure it out ⁉️
The short put has the higher premium, so it’s the dominant leg. The names associated with this strategy are:
• Short put spread
It’s a “short put spread” because the short put is the dominant leg.
• Bull put spread
It’s a “bull put spread” because the dominant leg is bullish.
• Credit put spread
It’s a “credit put spread” because the short put is more expensive, creating a net credit (net sale).
When premiums are provided, identifying the dominant option is straightforward: the option with the larger premium is always the dominant leg.
2️⃣ The strike prices
If premiums aren’t provided and you’re dealing with a vertical (price) spread, you can use strike prices to identify the dominant option. A vertical spread uses different strike prices with the same expiration.
Use these guidelines:
• Call spreads: low strike price
• Put spreads: high strike price
This still follows the same idea: the dominant option is the more valuable leg.
• For calls, a lower strike price is more valuable than a higher strike price. A $20 call should be more expensive than a $30 call because the $20 call gives the right to buy at $20 (a better deal than buying at $30).
👉 Let’s try a vertical call spread.
An investor goes short 1 MNO Jun 80 call and long 1 MNO Jun 95 call. What are the three names associated with this call spread?
The short call has the lower strike price, so it’s the dominant leg. The names associated with this strategy are:
• Short call spread
It’s a “short call spread” because the short call is the dominant leg.
• Bear call spread
It’s a “bear call spread” because the dominant leg is bearish.
• Credit call spread
It’s a “credit call spread” because the short call is more expensive, creating a net credit (net sale).
👉 Now compare that to put spreads.
For puts, a higher strike price is more valuable than a lower strike price. A $50 put should be more expensive than a $40 put because the $50 put gives the right to sell at $50 (a better deal than selling at $40).
One more vertical spread example, this time with puts:
An investor goes short 1 RTR Dec 120 put and long 1 RTR Dec 140 put. What are the three names associated with this put spread?
The long put has the higher strike price, so it’s the dominant leg. The names associated with this strategy are:
• Long put spread
It’s a “long put spread” because the long put is the dominant leg.
• Bear put spread
It’s a “bear put spread” because the dominant leg is bearish.
• Debit put spread
It’s a “debit put spread” because the long put is more expensive, creating a net debit (net purchase).
3️⃣ The expirations
If premiums aren’t provided and you’re dealing with a horizontal (calendar/time) spread, you can use expirations to identify the dominant option. A horizontal spread uses different expirations with the same strike price.
In a horizontal spread, the dominant leg is the contract with the longer time to expiration.
As we learned in a previous chapter, time value is the part of an option’s value that comes from having time remaining. More time until expiration generally means a more valuable contract. For example, an option expiring in February is typically more valuable than an option expiring in January because the holder is paying for extra time, and the seller is taking on the obligation for longer. So the option with the longest time to expiration is the dominant leg.
👉 Let’s look at an example:
An investor goes short 1 TM Sep 55 call and long 1 TM Oct 55 call. What are the three names associated with this call spread?
The long call has the longer time to expiration, so it’s the dominant leg. The names associated with this strategy are:
• Long call spread
It’s a “long call spread” because the long call is the dominant leg.
• Bull call spread
It’s a “bull call spread” because the dominant leg is bullish.
• Debit call spread
It’s a “debit call spread” because the long call is more expensive, creating a net debit (net purchase).
📊 Key points
Naming spreads
• The dominant leg names the spread
Identifying the dominant leg
• Highest premium
• Vertical call spreads: low strike price
• Vertical put spreads: high strike price
• Horizontal spreads: long expiration
