Introduction

Spread strategies are an essential component of trading strategies, involving the simultaneous purchase and sale of multiple options or derivatives with differing strike prices, expiration dates, or both. These strategies are employed to manage risk, capture potential gains, and take advantage of various market scenarios. This chapter will delve into the different types of spread strategies, their purposes, and how to calculate their payoffs.

Spread strategies are a set of options trading techniques that involve combining multiple positions to take advantage of price movements and volatility changes. These strategies are particularly useful when an investor expects a certain level of price movement but seeks to mitigate risk. By utilizing spread strategies, traders can minimize the impact of unpredictable market fluctuations.

Types of Spread Strategies

Spread strategies can be broadly classified into several categories, including vertical spreads, horizontal spreads, and diagonal spreads. Each type has its unique characteristics and profit potential:

• Vertical Spreads: These involve the simultaneous purchase and sale of options with the same expiration date but different strike prices. Vertical spreads include bull spreads (buying a lower strike call and selling a higher strike call) and bear spreads (selling a higher strike call and buying a lower strike call). These spreads limit both potential gains and losses.

• Horizontal Spreads: Also known as time spreads or calendar spreads, these involve options with the same strike price but different expiration dates. Traders use these spreads to capitalize on differences in time decay between short-term and long-term options.

• Diagonal Spreads: These involve options with both different strike prices and different expiration dates. Diagonal spreads offer a more flexible approach to trading different market expectations, combining aspects of vertical and horizontal spreads.

Payoffs for Each Spread Strategy

The payoffs of spread strategies are determined by the difference between the strike prices of the options involved, the net premium paid or received, and the market price of the underlying asset at expiration. Here’s a breakdown of how payoffs are calculated for some common spread strategies:

• Bull Call Spread Example: Suppose an investor buys a call option with a lower strike price (K1) and simultaneously sells a call option with a higher strike price (K2). The maximum potential loss is the initial net premium paid, while the maximum gain occurs when the underlying asset’s price is above K2 at expiration.

• Bear Put Spread Example: In this strategy, an investor sells a put option with a higher strike price (K1) and simultaneously buys a put option with a lower strike price (K2). The maximum loss is limited to the difference between the strike prices minus the initial premium received, and the maximum gain occurs when the underlying asset’s price is below K2 at expiration.

• Calendar Spread Example: With a calendar spread, an investor simultaneously buys and sells options with the same strike price but different expiration dates. The goal is to profit from time decay. The maximum loss is the initial net premium paid, and the maximum gain occurs when the underlying asset’s price remains close to the strike price at expiration.