Option Spreads for Beginners

In this article, we want to discuss what option spreads are.

This is going to be an introduction to option spreads for beginners, where we learn about what they are and how they work.

Understanding different types of spreads is important before jumping into strategies like when to use them based on being bullish or bearish on a stock. For beginners, terms like ‘bullish’ might add confusion because it assumes knowledge of why you might expect a stock to rise or fall.

We’ll set strategy discussions aside for now and concentrate on understanding what option spreads are, which will make learning about when and why to use them much clearer as you advance.

What is an Option Spread?

An option spread involves buying and selling an equal number of options contracts on the same stock. These can be either call options or put options, not a mix of both. The options must differ in strike prices and / or expiration dates.

Here are some examples using Tesla stock:

Vertical Spreads

These involve buying and selling options with different strike prices but the same expiration date.

• Buy a TSLA call option with a strike price of $150, expiring in one month.
• Sell a TSLA call option with a strike price of $160, expiring on the same date.

• Buy a TSLA put option with a strike price of $150, expiring in one month.
• Sell a TSLA put option with a strike price of $140, expiring on the same date.

Horizontal Spreads (Calendar Spreads)

Also known as calendar spreads, these involve buying and selling options with the same strike price but different expiration dates.

• Buy a TSLA call option with a strike price of $155, expiring in six months.
• Sell a TSLA call option with the same strike price of $155, but expiring in one month.

Diagonal Spreads

These involve buying and selling options with different strike prices and expiration dates.

• Buy a TSLA call option with a strike price of $160, expiring in six months.
• Sell a TSLA call option with a strike price of $165, expiring in one month.

Remember:

Option spreads are when you’re buying and selling the same amount and type of options (calls or puts) on the same underlying stock. What’s different is either the strike prices (vertical spreads), the expiration dates (horizontal / calendar spreads), or both (diagonal spreads).

Credit and Debit Spreads

Credit Spreads

In a credit spread, you sell an option that generates more premium than the cost of the option you buy. The concept of “credit” comes from the fact that the net transaction results in a credit to your trading account—meaning you receive more money from selling the option than you spend on buying another. Here’s how it breaks down for both calls and puts:

• For Call Options: You sell a call with a lower strike price and buy a call with a higher strike price.
• For Put Options: You sell a put with a higher strike price and buy a put with a lower strike price.

Key Points

• Credit Spread = Selling an option with a more favorable strike (collect more premium) + Buying an option with a less favorable strike (pay less premium).
• Resulting Transaction = Net Credit to your account.

Debit Spreads

A debit spread is an options trading strategy that results in a net cost, or “debit,” to your account. This happens because you’re buying an option that costs more than the option you are selling. Here’s a breakdown of how it works for both calls and puts:

• For Call Options: You buy a call option with a lower strike price and sell a call option with a higher strike price.
• For Put Options: You buy a put option with a higher strike price and sell a put option with a lower strike price.

Key Points

• Debit Spread = Buying an option with a more favorable strike (pay more premium) + Selling an option with a less favorable strike (collect less premium).
• Resulting Transaction = Net Debit from your account.

Other Names for the 4 Popular Vertical Spreads

Unfortunately there are a few other names for the 4 popular vertical spreads which can make studying them a bit confusing.

Bull Call Spread

• A bull call spread is the same as a long call spread or call debit spread.

Understanding the Terms

• Bull Call Spread:
  • “Bull” indicates that the strategy is used when you expect the stock price to go up.
  • “Call” refers to the type of option used in the strategy.
  • “Spread” implies that this strategy involves two or more option trades.
• Long Call Spread:
  • “Long” here means buying or holding a position that benefits if the stock price increases.
  • “Call” again specifies the type of option.
  • “Spread” indicates the combination of buying and selling calls.
• Call Debit Spread:
  • “Call” specifies the type of option.
  • “Debit” means that you will pay to enter the trade (the cost of the bought call is more than the income from the sold call).
  • “Spread” refers to the strategy of using two different call options.

Bull Put Spread

• A bull put spread is the same as a short put spread or a put credit spread.

Understanding the Terms

• Bull Put Spread:
  • “Bull” indicates expecting the stock price to stay the same or rise slightly.
  • “Put” refers to the type of options used.
  • “Spread” means it involves selling a higher-strike put and buying a lower-strike put.
• Short Put Spread:
  • “Short” highlights selling a put option which generates immediate income.
  • “Spread” indicates using two different put options.
• Put Credit Spread:
  • “Credit” means you receive more money from the option you sell than the cost of the option you buy.
  • “Spread” refers to the strategy involving two different put options.

Bear Call Spread

• A bear call spread is the same as a short call spread or a call credit spread.

Understanding the Terms

• Bear Call Spread:
  • “Bear” indicates expecting the stock price to stay the same or fall.
  • “Call” refers to the type of options used.
  • “Spread” means it involves selling a lower-strike call and buying a higher-strike call.
• Short Call Spread:
  • “Short” emphasizes selling a call option which generates immediate income.
  • “Spread” indicates using two different call options.
• Call Credit Spread:
  • “Credit” means you receive more money from the option you sell than the cost of the option you buy.
  • “Spread” refers to the strategy involving two different call options.

Bear Put Spread

• A bear put spread is the same as a long put spread or a put debit spread.

Understanding the Terms

• Bear Put Spread:
  • “Bear” indicates expecting the stock price to fall.
  • “Put” refers to the type of options used.
  • “Spread” means it involves buying a higher-strike put and selling a lower-strike put.
• Long Put Spread:
  • “Long” emphasizes buying a put option, which costs more than the option sold.
  • “Spread” indicates using two different put options.
• Put Debit Spread:
  • “Debit” means you pay more for the option you buy than the income from the option you sell.
  • “Spread” refers to the strategy

Example of a Vertical Spread

Let’s run through a practical example comparing the differences between buying Tesla (TSLA) stock outright, buying a call option, and setting up a vertical call spread. This will demonstrate why using vertical spreads can sometimes be a more advantageous option than the other methods, especially in terms of risk management and cost efficiency.

Example Setup Using Tesla (TSLA) Stock

Current Tesla Stock Price: $150

Option 1: Buying Tesla Stock Outright

• Action: Purchase 100 shares of Tesla at $150 per share.
• Cost: $15,000
• Potential Risk: Entire amount of $15,000 if Tesla’s stock goes to zero.
• Potential Reward: Unlimited. Each dollar increase in the stock price increases the investment value by $100.

Option 2: Buying a Call Option

• Option Selected: Buy a call option with a strike price of $150, expiring in one month.
• Cost of the Call Option (Premium): Let’s assume $10 per share, or $1,000 per contract.
• Potential Risk: $1,000 (total premium paid).
• Potential Reward: Unlimited above the break-even point ($160).
• Break-even Stock Price at Expiration: Strike price + premium = $150 + $10 = $160.

Option 3: Setting Up a Vertical Call Spread

• Setup:
  • Buy a call option with a strike price of $150, expiring in one month. Assume a cost of $10 per share ($1,000).
  • Sell a call option with a strike price of $160, expiring in one month. Assume you receive $5 per share ($500).
• Net Cost (Debit): $1,000 – $500 = $500
• Potential Risk: $500 (the net cost of the spread).
• Potential Reward: Maximum profit is capped. Calculated as the difference between strike prices minus net debit = ($160 – $150 – $5) = $5 per share, or $500 per contract.
• Break-even Stock Price at Expiration: Lower strike + net debit = $150 + $5 = $155.

Why Vertical Spreads Can Be Better

1. Lower Cost and Risk: The vertical spread reduces the initial cost from $1,000 to $500 compared to buying a call outright. This also lowers your total financial risk.
2. Defined Outcomes: Both potential reward and risk are clearly defined in a vertical spread. You know the maximum amount you can lose ($500) and the maximum profit you can make ($500).
3. Reduced Impact of Time Decay: By selling a higher-strike call, you offset some of the time decay on the bought call. The premium received from the sold call compensates for the time decay of the long call, which makes this strategy more resilient to sideways market movements.
4. Break-even More Favorable: The break-even point for the vertical spread ($155) is lower than for the bought call ($160), making it easier to start profiting as the stock doesn’t have to rise as much.

Practical Scenarios with ROI Analysis

• Scenario 1: Tesla’s stock rises to $165 at expiration.
  • Stock Purchase:
    • Profit: $15 per share x 100 shares = $1,500
    • Initial Investment: $15,000
    • ROI: ($1,500 / $15,000) x 100 = 10%
  • Bought Call:
    • Profit: ($165 – $160) x 100 = $500
    • Initial Investment: $1,000 (premium paid)
    • ROI: ($500 / $1,000) x 100 = 50%
  • Vertical Spread:
    • Maximum Profit Reached: $500
    • Initial Investment: $500 (net cost of spread)
    • ROI: ($500 / $500) x 100 = 100%

---

• Scenario 2: Tesla’s stock is at $155 at expiration.
  • Stock Purchase:
    • Outcome: Profit of $500 (100 shares x $5 gain per share from the initial $150 purchase price).
    • ROI: Approximately 3.33% ($500 profit / $15,000 initial investment).
  • Bought Call:
    • Loss: $500 (The intrinsic value of the call is $5 per share, or $500 for 100 shares, which is $500 less than the $1,000 paid for the premium).
    • ROI: -50% (Loss of $500 on the initial $1,000 investment).
  • Vertical Spread:
    • Outcome: Profit of $0 (The spread reaches its break-even point; the intrinsic value of the long call at $155 minus the net cost of the spread equals zero profit).
    • ROI: 0% (No gain or loss relative to the net debit of $500).

---

• Scenario 3: Tesla’s stock drops to $130 at expiration.
  • Stock Purchase:
    • Loss: $20 per share x 100 shares = $2,000
    • Initial Investment: $15,000
    • ROI: (-$2,000 / $15,000) x 100 = -13.33%
  • Bought Call:
    • Loss: $1,000 (full premium lost)
    • ROI: -100% (total investment lost)
  • Vertical Spread:
    • Net Loss: $500 (maximum loss)
    • Initial Investment: $500
    • ROI: (-$500 / $500) x 100 = -100%

Summary

These scenarios highlight the different financial dynamics of each trading strategy:

• The stock purchase provides a solid, albeit lower, percentage gain in a rising market but also exposes the investor to substantial capital requirements and significant losses in a falling market.
• The bought call offers substantial leverage (higher percentage gains for smaller moves in stock price) but with the risk of total investment loss if the stock price does not move favorably.
• The vertical spread offers the best risk management, significantly limiting both potential loss and reducing the capital required. While the gains are capped, the ROI is impressive when successful, demonstrating efficient use of capital.