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8.4  Spread Positions


he third type of strategy is called a spread position.  A  spread  is  a portfolio of calls (a call spread) or a portfolio of puts (a put spread).  In a call spread, you buy and sell different call options.  If they differ only by the strike price, this would be a vertical call spread.  The term vertical comes from the way option prices are sometimes reported.  The different strike prices are listed vertically, and the maturities are listed horizontally,  as in Table 8.1.

Table 8.1

Option Price Reporting and Vertical/Horizontal Spreads 

Expiration Date 1

Expiration Date 2

Strike 1 (K1)

Option Price

Option Price

Strike 2 (K2)

Option Price

Option Price

Following this terminology, a horizontal (or calendar) spread would fix the strike price (K) but vary the expiration date.  A diagonal  spread  would vary both strike price and expiration date.

Spreads come in two other varieties: bullish and bearish.  As the  names imply, if you (mainly) make  money  when  the  price  of  the  underlying security rises, you have a bullish position; and if you mainly make money when the price falls, you have a bearish position.  These positions are shown in Figures 8.6-8.9.

Figure 8.6

Bullish Call Spread


Figure 8.7

Bearish Call Spread


Figure 8.8

Bullish Put Spread

Figure 8.9

Bearish Put Spread


Other types of spread positions are ratio spreads, where the ratio is the number of calls (puts) bought at a higher strike per call (put) sold at a lower strike.  The writer of such a portfolio has a ratio back spread.  Figures 8.10 and 8.11 show the payoffs from a -1:2 call ratio spread and a 2:-1 put ratio spread.  Observe that in these positions a floor is imposed upon possible losses, whereas the position participates in any upside gain.  In the -1:2 call ratio spread depicted in Figure 8.10, no upper bound is imposed on the upside potential.

Figure 8.10

-1:2 Call Ratio Spread


The 2:-1 put spread in Figure 8.11 imposes an upper bound on the upside gain.

Figure 8.11

2:-1 Put Ratio Spread


Spreads can also be used to make profits when prices are expected to remain in a stable range.  A famous example of this is the butterfly spread, which consists of buying a low and high strike-price call and selling two medium strike-price calls.  The payoff from this position is depicted in Figure 8.12.

Figure 8.12

Call Butterfly Spread


The position in Figure 8.12 can also be engineered by selling the medium puts and buying the extreme strike-price puts, as shown in Figure 8.13.

Figure 8.13

Put Butterfly Spread


Calendar, or horizontal, spreads are difficult to illustrate, as  the expiration dates of the options are  different.  However, you can view the payoffs from such strategies in Option Tutor.   An option pricing model such as the Black-Scholes lets you value the long-dated option at the expiration date of the short-dated option, and examine the resulting payoffs as a function of the underlying stock price.

In the next topic, we discuss Combination Position Strategies.