An Introduction to Option Spreads

This is one of my favorite articles it is the basics of what made me interested in learning how to trade option spreads, specifically vertical credit spreads. So here is a walk down memory lane with a post of an article I had written a couple of years ago…

 

Options trading, just like other trading activities, requires a strategy. At the core of many options trading strategies is option spreads. An option spread is the position that is entered when the investor purchases or sells equal numbers of the same kind of options with the same underlying security. However, the strikes prices and expiration dates of these options differ.

Options spreads are divided into three different classifications, which include the horizontal spread, the vertical spread, and the diagonal spread. The options are classified according to strike price and expiration dates.

Horizontal spreads are also known as calendar or time spreads. These types of spreads consist of options with the same underlying security and strike prices. The options in this class have different expiration dates, though.

Vertical spreads are also called money spreads. These spreads contain options with the same underlying security and expiration month. However, the options have different strike prices.

Diagonal spreads consist of a sort of combination of the vertical and horizontal spread classification. The options in this class have the same underlying security, but have different strike prices and 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.

Within these three spreads classifications, spreads are also classified by what they are designed to do. There are call and put spreads, bull and bear spreads, credit and debit spreads, ratio spreads and backspreads, spread combinations, and box spreads.

A call or put spreads is simply a spread that is created from call options or put options. If the spread is created from call options, it is known as a call spread. If a spread is created from put options, it is known as a put spread.

Bull and bear spreads are those that are created to benefit from a rise or fall in price of the underlying security. Bull spreads benefit from a rise in price, and bear spreads are profitable when the price decreases.

Credit and debit spreads are created based on premiums of the options. A net credit is received when the premiums of the options sold is higher than the premiums of the options purchased. A spread created from these types of transactions is called a credit spread. A net debit is taken by the investor when the premium of options sold is lower than the premium of the options purchased. A spread created from this scenario is known as a debit spread.

Ratio spreads and backspreads are spreads in which an unequal number of options are purchased and written simultaneously. A ratio spread is one in which more options are written than purchased. A backspread is one in which more options are purchased than written.

Spread combinations are just what the name implies, a combination of the different types of spread strategies. For example, an investor can create a bull put spread. This type of spread is created when both a bull spread and credit spread are combined.

A box spread is created from the combination of a bull call spread and a bear put spread. The expiration dates of the call and put options are identical. The resulting constant payoff at the exercise date is equal to the difference in strike values. The box spread basically constitutes loaning money to the counterparty until the date of exercise

 

credit spreads, diagonal spread, option spreads, vertical spreads

Bear Call Credit Spread on Boeing

Boeing lost the AirForce contract and has a strong resistance point at $85. Now would be a good time to place a bear call credit spread above the $90 strike. An April spread position will give you a 6 week trade and a 7.5% return.

Brent Archer agrees and you can read his post on his opinion of this credit spread trade here —> Boeing (BA) slides on lost Air Force contract

boeing, credit spread

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