What is an Options Spread?

Andrew Burger
Andrew Burger
Businessman with a briefcase
Businessman with a briefcase

An options spread is a trading strategy that involves the buying and selling of options contracts of the same class, i.e., call options or put options, with different strike prices and/or expiration dates, typically at the same time. Strictly speaking, the options should be based on the same underlying financial instrument, commodity, currency, or index; the same quantity of calls or puts should also be bought and sold at the same time, though this is not necessarily the case. Limiting risk is often the main objective when entering into an options spread as this involves taking opposing derivative positions. In addition, margin requirements for option spreads are lower than that for outright positions. As options are highly leveraged, they are also used to speculate on the future paths and relationships between financial instruments and commodities underlying the option contracts.

When entering into an options spread, an investor is taking on exposure to both sides of a market, i.e., long and short or bullish and bearish. The potential for profit depends on the relative changes in value of the different contracts. Simple option spreads, such as vertical call and put spreads, involve entering into two opposing transactions — i.e., the simultaneous buying and selling of call or put contracts with different strike prices and the same expiration date — known as "legs." More complex option spreads, such as butterfly spreads, calendar spreads, and ratio spreads, have three or more legs and are typically non-directional. This means that the potential profit or loss is not directly related to changes in price of the underlying instrument; rather these types of spreads' profit or lose value is based on changes in volatility and the rates of time decay.

An options spread may also involve the simultaneous buying and selling of calls or puts on related commodities that are refined or processed into various other products or associated financial instruments. Speculators and investors, as well as industry participants, may have a view as to how the relative values of crude oil and gasoline prices will change over time, for instance. Money and bond market investors may have a view as to how the relationship between interest rates of government securities and interbank borrowing and lending will change over time. For a relatively small capital outlay, option spreads can used to earn profits if the investor's view turns out to be correct while limiting overall exposure.

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      Businessman with a briefcase