The spread -- trading in two or more options with different strike prices -- can be confusing because there are dozens of varieties. It helps keep things clear to remember the following eight distinctions between types of spreads.
1. Different strike, same expiration, the vertical spread. The vertical spread is one where each side expires on the same date, but involves different strike prices. This is often the favored choice when current market value is halfway between two strikes.
2. Different expiration, same strike, the horizontal spread. If you like the idea of opening a position with segments expiring on different dates, the horizontal spread is worth considering.
3. Different expiration and different strike, the diagonal spread. Combining the previous two types, the diagonal spread consists of positions with different expiration dates and different strike prices.
4. Long spreads. Spread can consist entirely of long calls and/or long puts in vertical, horizontal or diagonal versions. This is appropriate for those with minimal approval levels or for traders not willing to go short.
5. Short spreads. A spread can also be made up of short positions, in vertical, horizontal or diagonal configurations. The call sides can be covered or uncovered; and the put side can be naked or covered with later-expiring long positions.
6. Call only or put only spreads. You can also limit your spreads to the use of calls only or puts only. Depending on where the strikes fall, either decision can be long or short, and also can be either bullish or bearish.
7. Combining calls and puts. Complicating matters even more, spreads can be made up of a combination of calls and puts - these can be long or short and bullish or bearish, as well as designed as vertical, horizontal or diagonal.
8. The weighted spread. The spread can also involve more positions on one side than the other, creating emphasis on bullish or bearish movement.
Confused yet? Spreads come in many varieties and offer flexibility in creating either speculative or synthetic positions. These are incredible instruments that can suit any risk profile and any opinion about the direction the market is about to take. As with all options, spread risks do vary and anyone entering a spread should be very familiar with the risks involved. But the spread is not a solitary format strategy: the varieties are practically endless.
Michael C. Thomsett is an options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press books are Put Option Strategies for Smarter Trading and Trading with Candlesticks.