What are Options Spreads?

Options spreads are options trading strategies that involve taking simultaneous opposing positions at different exercise prices or strike prices. Options pricing involves estimates regarding future volatility; options spreads are a useful tool for minimizing the risk from making incorrect estimates.

The simplest of options spreads is the vertical. A vertical consists of one long option, and one short one. Both must have the same expiration date, but will have different strike, or exercise, prices. Depending on which strikes are bought and sold, a vertical can be either bearish or bullish. Selling (or buying) a lower priced put (or call) option while buying (or selling) a higher priced one is bullish; taken in reverse, the vertical will be bearish. Vertical options spreads have limited risk but have limited profit potential.

Ratio spreads, or backspreads, are options spreads similar to verticals, except the number of options bought is not the same as the number of options sold. For example, a bullish ratio spread can be constructed by selling a lower priced call and buying twice as many higher priced calls. If the price moves dramatically higher, the spread will be profitable. Because of the dependence on a rapid movement in price, backspreads are classified as a volatility spread.

The butterfly strategy is a more complex options spread built from options bought and sold at three different strike prices. All three positions (legs) are of the same type; either all puts or all calls, and all with the same expiration date. If the underlying stock is at 100, a long butterfly could be made by buying puts (or calls) at 95 and 105 and selling twice as many puts (or calls) at 100. The maximum profit comes if the underlying stock is right at 100 at expiration, and the maximum loss occurs if the price moves past either 95 or 105. This is, in effect, the shorting of volatility. A short butterfly reverses the buys and sells, and conversely the maximum profit occurs if the price moves as far from 100 as possible. It is a bet on increased volatility.

A related options spread can built by combining a bullish call (or put) spread with a bearish one. If the two spreads are centered at the same price - for example short a put at 95, long a put and long a call at 100, and short a call at 105 - it is called an iron butterfly. In terms of profit and loss potential, it acts very much like a basic butterfly strategy. If the two spreads do not overlap, the position is called a condor.

All the above options spreads involve positions with identical expiration dates. Calendar, or time spreads, involve multiple positions with different expirations. A long time spread involves selling one option and buying another at the same exercise price but expiring at a later date. Like a long butterfly, it is a bet against increasing volatility. A short time spread is the converse; by selling the longer term option, the position is sensitive to increases in volatility.