Spreads

On the previous page, we reviewed the four basic trades of options, you may have noticed that each type has strengths and weaknesses.  When buying options time works against the buyer.  When selling options time works for the seller.  When buying options, potential gains are virtually unlimited, but not probable.  When selling options, potential losses are virtually unlimited but unlikely.  What if we could take the best of each type? With spreads we can.

A spread is created when a trader sells an option and buys the same kind of option with a different price and/or expiration.  By doing this, a position can be created with less risk than a short option and better odds of profit than a long option.  There are lots of variations and no best spread for all seasons, but as you learn about each, you can have a toolkit to establish positions that have the best probability of consistent positive returns.  

One of the biggest advantages of spreads is that they typically limit the capital required which leverage the potential for higher returns on capital.  We’ll cover that aspect with each type.

Let’s look at different categories of spreads.

Debit vs Credit Spreads

No matter what the details are, spreads will either generate a credit or cost a debit.  Credit spreads have a short option that is sold for more than the long option costs.  Establishing a credit spread generates a credit to the trader.  Credit spreads typically have a greater than 50% probability of profit, with the goal of having the credit decay with time.  Debit spreads have a long option that costs more than the short option is sold for.   Debit spreads are best set up to have about a 50% probability of profit, with profits coming from an increase of the debit amount.

From a capital standpoint, debit spreads only require the debit paid as capital at risk, and the premium collected from the short option reduces this cost.  On the other hand, credit spreads require the trader to have the difference between the strike prices in cash, much less than what is required when selling a naked option.  The cash amount required on hand is offset by the credit premium collected when the position is established.  Example?

Vertical Spreads

Vertical spreads are created by buying and selling a pair of options with the same expiration date.  

Vertical credit spreads typically are established with both options having strike prices out of the money. This creates a spread with positive theta and a high probability of profit.  

Vertical debit spreads work best with the long option bought in the money, and the short option sold out of the money.  With the right strike prices, the time value of the short option can cancel out the time value of the long option, making the position not sensitive to time decay, but still having decent potential for return.

Calendar Spreads

A calendar spread is created by selling an option at a near term expiration, and buying an option of the same type at a later expiration.  The short option will decay faster because it is closer to expiration.  This type of spread is sold for a debit and will be profitable as long as the underlying price stays close to the strike price. If selling options is about taking advantage of time, calendar spreads are a pure play to capture time decay.

The problem with calendar spreads, and what makes them a low probability trade, is that if the price moves away from the strike price in either direction, the debit value will collapse.  If the underlying price moves well into the money, both options will have about the same price, virtually all intrinsic value, and little time value.  If the underlying price moves well out of the money, the price of both options will approach zero.

You may wonder, can you create a credit calendar spread?  Well, you could, but this reverse of options would have a short option expiring later, which brokers would consider a potential naked short option, because the long option could expire and leave only the short option. This would require the trader to put up a lot of capital to secure the position.

Diagonal Spreads

What happens when you buy and sell options with different strike prices and different expirations? You have a diagonal spread. Diagonal spreads can be set up a variety of ways, but like calendars, they generally only make sense with the short option expiring earlier.  

A debit diagonal spread often is set up with the long option in the money with the short option out of the money.  The short option decays more quickly making theta of the position higher.  Some people refer to this set up as a “poor man’s covered call” or “poor man’s covered put” because it simulates covered calls and puts, but with a long option to offset the short option instead of shares of a security.  I really like this type of set up because it plays to the strength of each type of option to work together as a pair.

A credit diagonal spread can be created with a short out of the money option and a later expiring further out of the money option.  My experience is that these are hard to create in a way that provides a good consistent rate of return.  There are generally better choices with credit vertical spreads.