What is a Spread?

Terms & Characterizations: Part 1

In very simple terms, a spread is an option strategy, or position, that is comprised of both
long option contracts and short option contracts, of the same type (call or put), and on the
same underlying stock (or index). The sides of a spread, i.e., the long option(s) and the short
option(s), are commonly called the “legs” of the position, and for most spreads, each leg
would by itself benefit from an opposite move, bullish or bearish, in the underlying stock (or
index). As opposed to the outright purchase or sale of calls or puts, spreads are termed
“complex” strategies, a term that reflects their composition (of different pieces) rather than
any level of difficulty in understanding their use.

Spreads can be broadly categorized: vertical spreads, horizontal spreads and diagonal
spreads (or variations thereof). Each of these may further be categorized by type: call
(composed of only call contracts) or put (composed of only put contracts). The profit & loss
profiles of each spread category will be somewhat different. Let’s take a closer look at these
terms:

• Vertical (call or put) – legs have same expiration months but different strike prices
• Horizontal (call or put) – legs have same strike prices but different expiration months
(also called time spreads or calendar spreads)
• Diagonal (call or put) – combination of vertical or horizontal characteristics (different
strike prices and expiration months)

The spreads most commonly used by investors are vertical spreads and horizontal spreads.
Diagonal spreads are less commonly employed.

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Terms & Characterizations: Part 2
Another category of widely used complex option strategies comprised of two legs, but which
are not by definition spreads, are straddles and strangles. These don’t follow our definition of
spreads literally, because they are comprised of both calls and puts, either all long contracts
or all short ones. However, the two legs of each of these strategies can be characterized as
one bullish and one bearish. For educational purposes, or for sake of convenience, we will
include these strategies in the larger family of spreads.

In terms of cash flow upon establishing spread, straddle or strangle positions, there are debit
spreads and credit spreads:

• Debit spreads – total cash amount paid out for purchased (long) options is greater
than the total cash amount received for sold (short) options
• Credit spreads – total cash amount received for sold (short) options is greater than
the total cash amount paid out for purchased (long) options

Generally, a debit spread will be established (or purchased) at a net debit but will be closed
(sold or liquidated) at a net credit. The opposite is true for credit spreads; they may initially
be established (or sold) for a net credit, but will be closed (bought back or liquidated) at a net
debit. Sometimes, however, a spread may be established or closed for “even money,” or
with the total cash amount paid out equaling the total cash amount received.

Finally, some spread positions may be constructed synthetically. That is to say they are put
together from different pieces (or legs) compared to their “pure” versions, but will have similar
profit & loss profiles. Among these discussed are “iron butterfly spreads” and “iron condor
spreads.” You might come across references to these synthetic versions with different
names, but the descriptive term “iron” is a popular one. As well, you might see examples of
these synthetic spreads elsewhere that are put together from different pieces, but the “iron”
versions are the more commonly used.

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Spread Order Execution

The most efficient way to establish or close a spread position is with a spread order. This
type of order instructs your brokerage firm to execute each separate transaction involved
simultaneously, or to trade it as a package. Most commonly used spreads may be traded via
a spread order, but check with your brokerage firm about its procedures and capabilities to
do so, as well as the those of the exchange on which the order is to be executed.

A spread order details the specific option series and the number of contracts to be bought
and/or sold simultaneously. As well, instructions may be given to execute the order (open or
close the spread position) at a limit price, that is for a specific net debit, net credit, or for even
money. Or the order may give instructions to execute all transactions “at the market,” which
generally involves buying contracts at their ask price and selling contracts at their bid price.

The alternative to using a spread order is to trade the legs of a spread one at a time with
separate transactions, or to “leg” into or out of the spread. While many experienced
investors may use this procedure from time to time, it involves an element of risk the spread
order does not. This risk is that between the separate transactions the market may move
adversely, and that the intended net debit/credit amount may not be realized. Especially on
closing a spread in this manner, this risk could result in a profitable position becoming a
losing one.

To set realistic expectations for a spread order’s actual execution, look beyond the last sale
prices for the options being bought and/or sold. Check current bid/ask prices, just as you
should for an order involving only one option series.

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Calculating Profit & Loss

Investors with limited spread trading experience frequently find calculating profit & loss
amounts for spread positions a confusing process, especially if the spread has three or four
legs. The easiest way to handle this is to think less about profit/loss on each individual leg,
but instead on a net “money-in-money-out” basis. Focus on the net debit (or credit) amount
for opening the entire spread against the net credit (or debit) amount for closing the spread.
Overall, net profit or loss for the position will generally be the difference between these two
amounts.

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Early Assignment Risk

Having a spread position in no way alleviates or precludes the risk of early assignment on
any short option contracts that might be involved. Any investor with short call or put positions
should be aware of the market conditions in which early assignment on these contracts is
likely or even predictable. As a rule of thumb, when selling (writing) option contracts that are
already in-the-money, the risk of early assignment is greater. And with some spreads, early
assignment may commonly occur before the position becomes a profitable one, or perhaps
force you to take a loss before you’re planning to. Considering this risk in advance may help
in the selection of strategies and/or the strike prices chosen.

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More on Terminology

Despite the conventions used in this class for describing specific spread positions, you will
most likely see different conventions used elsewhere. For example, a 50/55 bull call spread
might just as commonly be described as a 55/50 bull call spread. A 2:1 backspread might
also be called a 1:2 backspread. The important terms in these examples are “bull call
spread” and “backspread” respectively.

The same goes for the names of certain spreads. A time spread is also a calendar spread or
a horizontal spread. A ratio spread may also be called a front spread. A backspread may be
called a ratio spread. Don’t let different terminology confuse you. Whenever you see
reference to a spread strategy, despite the way it may be labeled or named make sure you
recognize the strategy being discussed, as well as understand its risk/reward profile.

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The Strategies

All the spreads discussed in this class may be categorized with respect to their risk/reward
profiles.

Profit limited & Loss limited

Moderately Bullish Moderatley Bearish Neutral
Bull Call Spread X
Bear Call Spread X
Bear Put Spread X
Bull Put Spread X
Long Call Time Spread X
Long Put Time Spread X
Long Call Butterfly X
Long Put Butterfly X
Iron Butterfly X
Long Call Condor X
Long Put Condor X
Iron Condor X

Profit not limited & Loss limited

Very Bullish Very Bearish Neutral
Long Straddle X
Long Strangle X
Call Backspread X
Put Backspread X

Profit limited & Loss not limited

Neutral to slightly Bullish Neutral to slightly Bearish Neutral
Ratio Call Spread X
Ratio Put Spread X
Short Straddle X
Short Strangle X