Option Spreads

Classifying a spread in two steps

Step one: is it a debit or a credit? Compare the premiums. If the option bought costs more than the option sold, money leaves the account and it is a debit spread. If the option sold brings in more, it is a credit spread. You do not need to know which strikes are involved to answer this.

Step two: is it bullish or bearish? Here the rule is compact and worth memorizing exactly: the position takes its direction from the dominant leg — the one with the larger premium, which is the one that is closer to the money.

Applied to calls: buying the lower strike call and selling the higher strike is a debit and is bullish, because the more valuable option is the one you own and you want the stock up. Selling the lower strike call and buying the higher is a credit and is bearish.

Applied to puts: buying the higher strike put and selling the lower is a debit and is bearish. Selling the higher strike put and buying the lower is a credit and is bullish.

That produces the four names the exam uses: bull call spread (debit), bear call spread (credit), bear put spread (debit), bull put spread (credit). Two are debits and two are credits, and one of each is bullish.

And there is a general principle underneath, which is worth more than the four names: a debit spread investor wants the spread to widen, wants both options to be exercised, and profits when the stock moves in the direction of the long leg. A credit spread investor wants the spread to narrow, wants both options to expire worthless, and profits when the stock does not move against them.

The arithmetic

One pattern covers all four.

For a debit spread: maximum loss is the net debit. Maximum gain is the difference between the strikes minus the net debit.

For a credit spread: maximum gain is the net credit. Maximum loss is the difference between the strikes minus the net credit.

In both cases the two numbers add up to the difference between the strikes, which is a useful check: compute one and the other is the remainder.

Breakeven has an equally compact rule. For any call spread, breakeven is the lower strike plus the net premium. For any put spread, breakeven is the higher strike minus the net premium. Net premium here means the absolute net of the two, whether it is a debit or a credit.

A mnemonic that is genuinely reliable: call up, put down. Call spreads break even above a strike — the lower one; put spreads break even below a strike — the higher one.

Worked example, bull call spread. Buy 1 XYZ 50 call at 6, sell 1 XYZ 60 call at 2. Net debit is 4, or $400. Maximum loss is $400. The strikes differ by 10, so maximum gain is 10 minus 4, which is 6, or $600. Breakeven is the lower strike plus the net premium: 50 plus 4, which is 54.

Worked example, bear call spread. Sell 1 XYZ 50 call at 6, buy 1 XYZ 60 call at 2. Net credit is 4, or $400. Maximum gain is $400. Maximum loss is 10 minus 4, which is $600. Breakeven is still 50 plus 4, which is 54 — the same crossing point, because it is the same pair of contracts with the sides reversed.

Worked example, bear put spread. Buy 1 XYZ 60 put at 7, sell 1 XYZ 50 put at 2. Net debit 5, or $500. Maximum loss $500. Maximum gain is 10 minus 5, which is $500. Breakeven is the higher strike minus the net premium: 60 minus 5, which is 55.

Worked example, bull put spread. Sell 1 XYZ 60 put at 7, buy 1 XYZ 50 put at 2. Net credit 5. Maximum gain $500, maximum loss $500, breakeven 55.

Notice that the last two are the same numbers with the roles swapped, which is exactly what the zero-sum structure of a contract requires. If you compute one side, you have computed both.

Reading a spread question under time pressure

The questions look complicated and are not, provided you take them in a fixed order.

Write the two legs with their premiums. Net them; the sign tells you debit or credit, and immediately gives you one of the two extremes.

Subtract the strikes. That difference minus the net premium is the other extreme.

Apply call up, put down for breakeven.

Sanity check the direction: does the answer make sense for a bullish or bearish view? If a question describes a customer who expects a moderate rise and the position you have computed profits from a fall, you have mixed up a leg.

A further check that catches most errors: maximum gain plus maximum loss should equal the difference between the strikes, per share. If it does not, one of the three numbers is wrong.

One more distinction the exam draws. An investor establishing a spread for a small net debit with wide strikes has a large potential gain and a small maximum loss — a low-probability, high-payoff structure. An investor establishing a narrow credit spread has a high probability of keeping a small credit and a low probability of a larger loss. Neither is better; they are different bets, and a suitability question may turn on which one a customer's stated view supports.

Price, time and diagonal spreads

Everything above is a vertical or price spread: same expiration, different strikes. It is what the exam means by 'spread' unless it says otherwise.

A horizontal, calendar or time spread uses the same strike and different expirations. The investor buys the longer-dated option and sells the shorter-dated one, profiting from the faster time decay of the near contract. Time spreads are almost always debits, because a longer-dated option is worth more than a shorter-dated one at the same strike, all else equal.

A diagonal spread differs in both strike and expiration and combines the two effects.

The outline also asks about the economics of a position rather than only its extremes. Two are worth stating. A spread reduces both the capital committed and the potential return relative to the outright long option, which is the point — it is a way of paying less for a directional view by giving up the tail. And a credit spread's margin requirement is the maximum loss, which is the difference in strikes less the credit; that is covered in the margin lessons of Module 9, and it is why a credit spread is not free money even though it starts with cash coming in.