Understanding The Various Types Option Spread Trading

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 and sells (writes) equal numbers of the same kind of options with the same underlying security. However, the strike prices and expiration dates of these options differ depending on the type of spread.

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 different 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, and spread combinations.

A call or put spread 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 sold than purchased. A backspread is one in which more options are purchased than sold.

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, a type of credit spread, and combine it with a bear call spread to form the spread combination called an Iron Condor.

These different types of spreads are used for differing types of strategies and investors goals. Even the same type of spread can be used for different reasons. For example a credit spread can be conservative or aggressive depending on how close the strike prices are to the current value of the stock at the time the trade is placed.

Finally the reason a spread would be chosen over just buying or selling a single option is risk management. A trader using spread strategies can really reduce his risk by using spreads either by using less capital (debit spread) or adjustments (credit spreads) or no matter which direction the underlying stock or index goes (Iron Condor). Option Spreads are definitely a need to know core strategy, if you want to trade options.

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