Published orginally at Investopedia.com

By John Summa, CTA, PhD, Founder of OptionsNerd.com

Limiting Risk with Long and Short Options Legs

We have seen that a spread is simply the combination of two legs, one short and one long (but not necessarily in that order), in our simple call spread example in the previous chapter. Now let’s get into a little more detail in order to begin to understand how a spread can limit risk. After looking at the risk and reward of spreads versus outrights, the next step will be to explore how each spread works and what markets work best with available spread constructions, keeping in mind the changing risk profiles of each spread from the point of view of the position Greeks mentioned in the previous section.

Taking both sides in an option trade in the form of a spread creates an opposing dynamic. The long option risk is counterbalanced by the short option reward and vice versa. If you were to buy an out-of-the-money (OTM) call option on IBM and then sell a further out-of-the-money (FOTM) call option, you would have constructed what is known as a vertical call spread (we will discuss vertical spreads in all their forms in more detail later), which has much less risk than an outright long call.

When you combine options in this manner, you have what is known as a positive position Delta trade, as seen in Figure 2 of the previous chapter. Negative position Delta refers to option spreads that are net short the market. We will leave neutral position Delta spreads aside for the moment, returning to neutral spreads toward the end of this tutorial.

If IBM trades lower, for example, you would lose on the long OTM call option and gain on the short FOTM call option. But the gain/loss values will not be equal. There will be a differential rate of change on the option prices (i.e. they will not change by the same amount given the hypothetical drop in IBM stock, the underlying). The reason for the different rates of change in the prices of the two legs of the spreads is easy to understand – they are options with different strikes on the call options strike “chain” and, therefore, will have different Delta values (we will talk about Theta and Vega later).

Therefore, when IBM drops, the OTM long call option, having the larger Delta because it is closer to the money, will experience a bigger change (drop) in value than the change (drop) in the FOTM short call option. All other things being equal, a drop in IBM will cause the option spread value to decline, which in the case of this type of spread (a bull call debit spread) is always going to mean an unrealized loss in your account. But the loss is smaller than would have been the case if long just the OTM call.

On the other hand, if IBM rises, the opposite will occur. The OTM long call option will experience a greater rise in price than the FOTM short call option’s price. This causes the spread price to increase, resulting in unrealized profits in your account. In both cases, for simplicity, we assume that the IBM move occurs just after taking the spread position and, therefore, time value decay has not become a factor yet.

As you can see, the risks of being wrong are reduced with a spread, but this is balanced with reduced reward if you are correct. Obviously, as with most things in life, there is no free lunch. Nevertheless, a spread trade does offer greater control of unexpected market outcomes and can allow you to better leverage your capital, leaving more capital available to use with another trade or trades. This conserved capital allows for greater diversification, for instance. And with credit spreads (which will be discussed next), which profit from time value decay, the use of a spread can increase the power of your margin dollar. That is, your risk-reward ratio can be improved in many cases.

Having seen how spreads work at a very basic level, let’s turn to a closer examination of the mechanics of spreads with a look at what are called debit spreads, and then their reverse, spreads that generate a net credit in your account when opened, or credit spreads.