When I first started dipping my toes in the trading world, the first thought that came to mind when I heard the word call spreads, was something I put on food. What is a call spread? Fortunately or unfortunately the word “spread” in the trading arena has nothing to do with culinary delights. Having said that, every options trader should know what spreads are and how to make money from the different strategies.
If you’re starting, or even a seasoned veteran, this article will help you out! You won’t only know what an option spread is but you will know all the different spreads that exist.
This is very powerful because if you fully understand options spreads, you will understand ALL options strategies! So without further ado, let’s get started.
What Is a Call Spread?
- A key point to remember is that call spreads consist of call options only. In a nutshell, when the same number of call options are bought and sold at the same time its a call spread. Your profit is limited, but on the plus side, your risk is minimal. So far, so good. And they are cheaper to implement. What’s more, call spreads can be used to make money from a bull, bear or neutral market! So far, very good.
What Is an Options Spread?
First things first, before I start explaining the different types of options spreads, it is crucial to understand what exactly options spreads are.
For starters, they’re first created by buying and selling options on the same underlying asset but at different strike prices. Moreover, the options may have the same or different expiration dates depending on the strategy you’re employing.
It’s important to remember an options spread consists of only one type of option. Which means they consist solely of call or put options, not both.
Are you still with me? A second important thing to remember is an option spread has the same number of long as short options.
Let me give you a concrete example to make it clear for you. I entered an option spread by employing the following:
- 1 ABC short call with a strike price of 100 that expires in 40 days.
- 1 ABC long call with a strike price of 105 that expires in 40 days.
As you can see, the only difference in the options above is their strike price (100 vs. 105) and the opening transaction steps. I bought one call option, and I sold a second call option. Simple as that.
Let’s Recap Options Spreads
- All options are on the same underlying asset (e.g. ABC).
- All options are of the same type (either call or put).
- An options spread always consists of the same number of purchased as sold options (e.g. ten short and ten long).
In other words, an options spread only differ in regards to strike price and/or expiration date. That’s it. It’s that simple. So please keep this in mind when I start to talk just in case you feel overwhelmed.
But before we move on, remember this: Even though the options only differ in regards to 1-2 factors, it is still possible to create a wide assortment of spreads.
For example, vertical, horizontal, diagonal, credit, debit and bull spreads are all different types of option spreads. Next up, I will walk you through all the different kinds of option call spreads.
Vertical Call Spreads
- Of all the different options spreads one can employ, the most basic is the vertical spread. They differ only in regards to strike price. They are directional strategies, which means they mainly profit when the price of the underlying moves. In other words, you use this strategy to take advantage of price movement. What’s excellent about vertical spreads is they can be bullish or bearish. That’s why they are also referred to as bull/bear spreads.
What I like about all vertical spreads is your risk and profit is defined. You know the maximum you can profit and lose when getting into the trade.
IF you’re anything like me, you want to know how much you stand to lose. In this case, you need only one calculation to determine your maximum risk and maximum profit:
Width of Strikes × 100 − Net Credit or Debit
Bull Vertical Call Spread (Debit)
When you think the price of the underlying will go up before the call option expires, use a bull call vertical spread.
Bear Vertical Call Spread (Credit)
On the flip side, if you feel the price of the underlying will fall before the expiry date, use a bear call vertical spread.
Horizontal (Calendar) Call Spread
To profit from changes in implied volatility and from time decay, use a calendar call spread. A calendar or horizontal call spread is created when you buy long term call options and sell near term call options.
Both have the same strike price. They differ only in regards to the expiration date. Based on factors such as the near-term outlook, you can use the neutral or bull calendar call spread.
Neutral Calendar Call Spread
Just like the term implies, if the short term outlook is neutral, use a neutral calendar spread. And to construct the spread, use at-the-money call options.
As you know, with options, time can either be on your side or not. In this case, time is on your side. The near term options experience rapid time decay, and this is how you make money. Capitalizing on the rapid time decay is the main objective of this strategy.
Bull Calendar Call Spread
If you’re long-term bullish on the underlying yet want to make some money in the short-term, a bull calendar call spread may be for you.
You simply sell near term calls to ride out the long term call for a discount. And in some cases, even for free. In these cases, use out-of-the-money call options.
Diagonal Call Spread
Diagonal spreads are a combination of both vertical and horizontal spreads. In other words, they try to profit from changes in both the underlying asset’s price and implied volatility/time.
To create this type of spread, use the same number of long as short options with different strike prices and different expiration dates.
The main difference between the bull calendar call spread and a diagonal one is the near term outlook. Honestly, this difference is slight as the diagonal call spread is just a bit more bullish.
Generally speaking, vertical spreads are the simplest of the three main options strategies. Due to the different expiration dates, horizontal and especially diagonal spreads are much more complicated.
Therefore, I wouldn’t necessarily recommend trading horizontal or diagonal spreads if you aren’t entirely familiar with them.
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