Option Spreads: Debit Spreads Structure
Published orginally at Investopedia.com
By John Summa, CTA, PhD, Founder of OptionsNerd.com
Spreads, as we have seen, are constructed by taking positions on the long (buying the option) side while simultaneously taking a position on the short (selling the option) side of the market. Figure 1 lists the major characteristics of long options which, as you may already know, offer unlimited potential profits with limited risk measured in the form of the premium paid for the option. And as you can see in Figure 2, selling options presents just the reverse, that is, unlimited potential losses with limited potential profit.
Therefore, when we combine these into a spread, the unlimited risk posed by selling an option (such as our FOTM IBM call option from previous examples), is hedged by the purchase of the OTM IBM call. Clearly, if IBM moves up to the strike of the sold option and it gets in the money, it only means that the long option in the spread will be gaining, but only profitably up to the strike of the short option (where gains are offset with losses, ultimately at 100%). If at expiration the short option is in the money, the long option will have offset any losses incurred on the short option. So where does the profit arise?
Looking at the spread in terms of expiration helps to reveal the profit/loss dynamics – most importantly, the potential profits. But we will need to go to a greater level of detail to show this. Let’s look at our IBM bull call spread again, but this time, we’ll add some more detail in terms of actual strikes prices and a month.
Let’s assume that IBM is trading at 82, and the OTM long call is the October 85 call option trading at 3.00 ($300). When we combine this with our FOTM short call option, using, for example, the October 90 trading at 1.20 ($120), we get a vertical bull call spread, one of the most popular spread buying strategies used. Here we have bought the Oct 85, which is out of the money because the stock is trading below the strike of the call at 82. We paid $300 for this leg.
Had we not created a spread, this outright position would have a maximum loss potential of $300. There would also be unlimited profit potential should IBM move above 88 (85 + 3 = 88 breakeven) by expiration in October (the third Friday). But when we drop in another leg to create a bull call vertical spread, the total risk drops to $180 ($300 – $120 = $180). We took in $120 for the sale of the FOTM short call (Oct 90), thus reducing our total outlay upon opening the position to $180 (our new maximum loss amount).
This is now the maximum risk. The cost of this reduced risk comes in the form of limited upside profit potential. Instead of unlimited upside profit potential, the maximum profit potential is capped at $380 per spread. This amount is determined by taking the size of the spread (90 – 85 = 5) and subtracting the premium paid for the spread (1.80), leaving 3.20 (or $320) in potential profits. The long call will profit up to the strike of the short option, at which point the long call gains are canceled by the short call losses. As seen in Figure 3, since we paid $180 for the spread and its value at expiration if at the short strike or higher can never be more than $500, the net gain would be $320 ($500 – $180 = $320).
We will come back to more examples of vertical spreads, using puts as well as calls as examples. For now, it is important to understand the basic risk/loss parameters in this vertical call spread since the core concept largely carries over to other spread constructions.
Go to Part 5 – Option Spreads: Credit Spreads Structure