Options spreads are multi-legged trading strategies used to limit risk while also capturing the potential for profits. Traders using an option spread simultaneously buy multiple options with the same underlying asset with different strike prices, different expiration dates, or both.
Understanding options spreads can help you decide whether these strategies will work for your portfolio, and which one to use in a given situation.
Credit and Debit Spreads
The difference between credit spread options and debit spreads is that an options trader sells one (credit), and buys the other (debit). When a trader sells an option, they receive a premium (a credit) to their account. Conversely, when they buy an option, they pay a premium to open the position, resulting in a debit to their account.
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3 Common Option Spread Strategies
In options spread strategies, the trader buys and sells multiple options pegged to the same underlying asset or security. The type of options that the trader buys and sells are all of the same type (i.e., they’re all call options or put options), and they either have different strike prices or expiration dates.
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There are several different types of option spreads. Here’s a look at a few common ones:
1. Vertical Spread Options
A vertical spread is an options strategy in which the options have the same expiration date but different strike prices. There are four types of vertical spread options that investors use depending on whether they are bullish or bearish and whether the spread is a debit or credit.
Bull Call Spreads
A bull call spread strategy involves buying a call option, and then also selling another call at a higher strike price. The call spread options have the same underlying asset and expiration date.
Investors using this bull spread options strategy anticipate an increase in the value of the underlying asset. With this strategy, a trader caps their potential losses to the net premium they paid for the options (essentially hedging their risk). Their maximum gain is capped at the differences in strike prices, minus the net premium paid.
For example, a trader buys a call option on Stock X at a strike price of $10, for a premium of $2. They also sell a call option with an identical expiration date at a strike price of $12, receiving a premium of $1. This is referred to as a “debit” spread, as the trader pays a net premium (of $1 in this case) to buy into their position.
Bear Call Spreads
The opposite of a bull call spread, a bear call spread benefits when the underlying asset’s value decreases. If we stick with Stock X from our previous example, a trader using a bear call spread would anticipate that Stock X’s value is going to decrease.
As such, the trader sets up the spread by selling a call option, and buying another call option at a higher strike price—the inverse of the bull call spread method. This is a “credit” spread,, so the trader can not gain more than the net premium the trader received for the position. Their potential loss is capped at the differences in strike prices.
Example: A trader sells a call option on Stock X at a strike price of $10, and buys another call at a strike price of $12.
Bull Put Spreads
A bull put spread is similar to a bull call spread, but it involves puts rather than calls. Using a bull put spread, a trader anticipates an increase in the underlying asset’s value. In our example, the trader would sell a put option at a strike price of $10, and simultaneously buy another at a lower strike price, say, $8.
The trader can not lose more than the difference between the strike prices or gain more than the premium received.
Bear Put Spreads
A bear put spread is the inverse of a bull put spread. In our example, the trader would buy one put option at a $10 strike price, and simultaneously sell another put at a lower strike price, like $8.
The trader can not lose more than the net premium the trader paid to take the position (again, because this is a “debit” spread) or gain more than the difference in strike prices.
2. Horizontal Spreads
Horizontal spreads (also called “calendar spread options”) involve options with the same underlying asset, the same strike prices, but different expiration dates. The main goal of this strategy is to generate income from the time decay effects, or volatility of the two options.
There are also two main types of horizontal spreads.
Call Horizontal Spreads
A call horizontal spread is a strategy which a trader would employ if they believe that the underlying asset’s price would hold steady. In this case, the trader would buy a call with an expiration date on January 15th, for example, and sell another call with a different expiration date, like January 30th.
The trader can also reverse these positions, by selling a call option that expires on January 15th, and selling another that expires on January 30th. The two positions with differing expiration dates act as buffers, reigning in potential losses (the premium paid) and gains.
Put Horizontal Spreads
Put horizontal spreads similar to call horizontal spreads, except that traders utilize puts instead of calls.
3. Diagonal Spreads
Finally, we have diagonal spreads, which incorporate elements from both vertical and horizontal spread strategies. That is, diagonal spreads involve the same option types and underlying asset (the same as before), but with differing strike prices and differing expiration dates.
Diagonal spreads—with different strike prices and expiration dates—allow for numerous combinations of options, making them a fairly advanced strategy. They can be bearish, and bullish for example, while also using calls or puts, with different time horizons (long or short).
Other Options Spreads
While we’ve covered the main types of options spread strategies, there are a few more you may run into.
Butterfly Spread Options
A butterfly spread incorporates multiple strike prices, and can utilize either calls or puts. It also combines a bull and bear spread across four different options.
An example would be a trader buying a call at a certain strike price, selling two more calls at a higher strike price, and then buying another call at yet an even higher strike price—of equal “distance,” or value, from the two central calls. This results in a cap on losses and gains, with the trader realizing gains depending on volatility levels of the underlying asset.
Box Spread Options
A box spread option strategy involves a bear put and a bull call with identical strike prices and expiration dates. Under very specific circumstances, traders can use the strategy to create profitable arbitrage opportunities.
There are several different options spreads strategies that traders use to limit their losses and achieve potential gains based on their projections about the price of a specific asset. Options strategies can get complicated, but you don’t need to invest in derivatives in order to build a portfolio.
Whether you’d rather start slow or dive into derivatives, a user-friendly options trading platform like SoFi can help in your investing journey. SoFi’s platform offers an intuitive design and access to educational resources about options. You’ll have the ability to trade from either the mobile app or web platform.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.