Spreads come in a vast variety of combinations, shapes and sizes. One of the best ways to distinguish spreads is by their geometric look. The three types -- horizontal, vertical, and diagonal -- can be graphically used to explain how the spread is put together.
A spread can consist of several combinations:
- calls only
- puts only
- calls and puts
- long positions only
- short positions only
- long and short positions
That is a lot of variety. Most people start out with a basic understanding of a spread’s definition. It is two (or more) options on the same underlying stock, opened at the same time, and designed with offsetting profit or loss potential. That is a basic definition. But there is more.
A horizontal spread can be envisioned as a straight line from right to left, with the two ends representing different expiration dates but the same strike price. This variety of spread involves offsetting positions (such as a short call offset by a later-expiring long call) with identical strike prices. The use of different expiration dates is based on the changes in time value.
A vertical spread can be thought of as a straight line moving up and down. The two ends of the vertical line represent different strike prices, but the same expiration date. It is the opposite of the horizontal spread. The strategic idea is the same, though. The use of different strikes at the same expiration is meant to take advantage of not only declining time value as expiration approaches, but also to maximize potential profits based on the proximity between strike and current price per share of the underlying stock.
A diagonal spread is a combination of horizontal and vertical. It requires different strike prices and different expiration dates. Envision this version as a diagonal line, with each end representing the strike and expiration. It can move diagonally up or down. An upward diagonal means the later-expiring option has a higher strike, and a downward diagonal means the later-expiring option has a lower strike. The importance of this formation varies based on whether the positions are long or short, and on whether the position consists of calls or puts.
The great aspect to options trading is that the possible combinations and design of strategies is endless. You can create a position using single options, spreads, or straddles to create desired levels of risk (everything from high-risk speculative to ultra-low risk conservative); short positions can be covered with stock or other options; and maximum profit and loss levels can be created with the skillful use of spreads. In other words, options trading can be designed to suit any goal and any risk level. You can insure paper profits, swing trade, create conservative current income, or manage your portfolio with a vast variety of options strategies.
Michael C. Thomsett is an options author and has written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Put Option Strategies for Smarter Trading.