Option Spreads

Explained: bear spread bull spread butterfly spread calendar spread call spread cartwheel collar costless collar fence option spread payoff payoff diagram put spread putting on a spread ratio call spread ratio put spread straddle strangle wrangle

Payoff of a Long Put Position Exhibit 1

The payoff of a long put equals any intrinsic value of the option at expiration less the premium paid for the option.

A long put strategy breaks even if the underlier falls by an amount equal to the option premium. If the underlier falls further than that, the position will be profitable. The payoff diagram for a short call is illustrated in Exhibit 2:

Payoff of a Short Call Position Exhibit 2

The payoff of a short call equals the option premium received for the option less any intrinsic value of the option at expiration.

This strategy will lose money if the underlier appreciates by an amount greater than the option premium.

An option spread is a position comprising two or more options on the same underlier. Some spreads have standard names. A straddle comprises a put and a call with the same expiration and struck at the same price—usually at the money. Long and short straddle payoffs are depicted in Exhibits 3 and 4.

Payoff of a Long Straddle Exhibit 3

A long straddle is a bet on high volatility. It makes money if the underlier value moves significantly either up or down.

Payoff of a Short Straddle Exhibit 4

A short straddle is a bet on low volatility. It makes money as long as the underlier value does not change too much.

A strangle is similar to a straddle, but both options are struck out of the money. For this reason, a long strangle is cheaper than a long straddle, but it requires a larger move in the underlier to be profitable.

Payoff of a Long Strangle Exhibit 5

A long strangle comprises out-of-the-money put and call options. It is cheaper than a long straddle, but less likely to be profitable.

Traders don't generally talk about "buying" or "selling" an options spread because some spreads entail both the purchase and sale of options. For this reason, it is more common to speak of putting on a spread. A collar (or fence) is a spread comprising a long (short) call and a short (long) put, both out-of-the-money and for the same expiration. The strikes can be chosen so that the purchase (sale) price of the call exactly offsets the sale (purchase) price of the put so the spread is a costless collar.

Payoff of a Costless Collar Exhibit 6

A costless collar comprises a long call and a short put. Both are out-of-the-money and are for the same expiration. Strike prices are chosen so that the cost of purchasing the call is offset by the income from selling the put.

A call spread (also called a bull spread) comprises a long call at one strike price and a short call at a higher strike price. Both options are for the same expiration. A call spread is an inexpensive alternative to simply buying a call. It has limited upside potential, but income from selling the high-strike call offsets the cost of purchasing the low-strike call.

Payoff of a Call Spread Exhibit 7

A call spread is long a call at one strike and short a call at a higher strike. Both options are for the same expiration. Call spreads are also called bull spreads.

A ratio call spread is a call spread in which the low and high strike calls are not bought and sold in equal proportions. Exhibit 8 depicts the payoff of a ratio call spread with one low price call bought and two high strike calls sold.

Payoff of a Ratio Call Spread Exhibit 8

This exhibit depicts the payoff diagram for a ratio call spread where one low strike call is purchased and two high strike calls are sold. In this particular example, the income from selling the high strike calls exceeds the expense of buying the low strike call.

Put spreads (also called bear spreads) and ratio put spreads are constructed similarly. High strike puts are purchased and low strike puts are sold. The payoff diagram for a put spread is depicted in Exhibit 9:

Payoff of a Put Spread Exhibit 9

A put spread is long a put at one strike and short a put at a lower strike. Both options are for the same expiration. Put spreads are also called bear spreads.

A ratio call spread or a ratio put spread is said to be long or short if it is net long options or net short options. For example, the spread in Exhibit 8 is a short ratio call spread. A long (short) wrangle is long (short) both a ratio call spread and a ratio put spread. For example, puts might be struck at 90 and 100 with calls struck at 100 and 110.

A cartwheel is long (short) a ratio call spread and short (long) a ratio put spread.

A butterfly spread is a long strangle with a short straddle. Strikes for the strangle bracket the strike for the straddle.

Payoff of a Butterfly Spread Exhibit 10

A butterfly spread comprises a long strangle with a short straddle.

A calendar spread is a long-short position is two calls or two puts. Both options have the same strike, but they have different expirations.

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chooser option A form of derivative instrument that offers an inexpensive alternative to a straddle. delta hedge A type of hedge that is widely used by derivative dealers to reduce or eliminate a portfolio's exposure to some underlier. dynamic hedging A technique that is widely used by derivatives dealers to hedge gamma or vega exposures. futures spread A long-short futures position. Greeks A set of factor sensitivities used to measure risk exposures related to options or other derivatives. option A type of derivative instrument. option pricing theory The body of financial theory used by financial engineers to value options and other derivative instruments. put-call parity A formula that relates the price of a put to the price of a corresponding call. range forward Costless collars can be used to hedge a short position in an underlier. time value and intrinsic value The two components that comprise an option's market value.
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