Options Combinations

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Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved.

Vertical spreadsor money spreads, are spreads involving options of the same underlying security, same expiration month, but at different strike prices. Horizontal, calendar spreadsor time spreads are created using options of the same underlying security, same strike prices but with different expiration dates.

Diagonal spreads are constructed using options of the same underlying security but different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads.

Any spread that is constructed using calls can be referred to as a call spread, while a put spread is constructed using put options. If a spread is designed to profit from a rise in the price of the underlying security, it is a bull spread. A bear spread is a spread where favorable outcome is obtained when the price of the underlying security goes down. If the premiums of the options sold is higher than the premiums of the options purchased, then a net credit is received when entering the spread.

If the opposite is true, then a debit is taken. Spreads that are entered on a debit are known as debit spreads while those entered on a credit are known as credit spreads. There are also spreads in which unequal number of options are simultaneously purchased and written. When more options are written than purchased, it is a ratio spread. When more options are purchased than written, it is a backspread.

Many options strategies are built around spreads and combinations of spreads. For example, a bull put spread is basically a bull spread that is also a credit spread while the iron butterfly can be broken down into a combination of a bull put spread and a bear call spread. A box spread consists of a bull call spread and a bear put spread.

The calls and puts have the same expiration date. The resulting portfolio is delta neutral. For example, a January box consists of:. A box spread position has a constant payoff at exercise equal to the difference in strike values. Thus, the box example above is worth 10 at exercise. For this reason, a box is sometimes considered a "pure interest rate play" because buying one basically constitutes lending some money to the counterparty until exercise.

The net volatility of an option spread trade is the volatility level such that the theoretical value of the spread trade is equal to the spread's market price. In practice, it can be considered the implied volatility of the option spread.

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The real benefits of options trading come with using options spreads. It's perfectly possible to make profits under any market condition by simply using a combination of the straightforward buying and selling of calls and puts, but if you can learn to use options spreads then you will discover many more opportunities to make profits.

An options spread basically consists of taking a position on two or more different options contracts that are based on the same underlying security. For example, if you buy contracts on a particular stock and also write contracts on that same stock, then you have essentially created an options spread.

They are primarily used for two specific reasons, limiting the risk and lowering the upfront costs of taking a particular position. However, there are many, many different types and some of them are very simple while others are more complex.

There are also a number of different ways that they can be classified. In this section we look at the main types, how they work, and how they are created. The following types of are all covered, along with some further information on them in your trading strategy. You should be aware that a number of them can fall into multiple categories. The simplest way to classify a spread is on what basic type of options are used — calls or puts.

Although some spreads can use a combination of both, most of them use either just calls or just puts. Any spread that is made up using only calls is known as a call spread, while one that is made up using only puts is known as a put spread.

Spreads can also easily be classified based on the capital outlay involved. When you create one you will either incur an upfront cost or receive an upfront credit. If you incur an upfront cost by spending more on buying contracts than you receive from writing contracts, then this is known as a debit spread.

If you receive an upfront credit by spending less on buying on contracts than you receive from writing contracts, then this is known as a credit spread. Another method for classifying spreads is based on the positions of the options relative to each other on an options chain.

Spreads that involve buying and writing contracts of the same type, same expiration date, and the same underlying security but with different strike prices would appear vertically stacked on an option chain and as such are known as vertical spreads.

Those that involve buying and writing contracts with different expiration dates, but the same type, same strike price, and same underlying security are known as horizontal spreads. Buying and selling options that have different strike prices and different expiration dates, but are the same type and same underlying security, is creating a diagonal spread. These involve options that have different expiration dates.

Horizontal spreads and diagonal spreads are both examples of calendar spreads, but there are other types too. They are essentially used to try and profit from differing rates of time decay between the contracts written and the contracts bought. This is applied to any spread that involves buying and selling differing amounts of options contracts, as opposed to buying an amount of contracts equal to the amount written. Typically they involve writing more contracts than are being bought, but the ratio can work either way around depending on what strategy is being used.

The different types of spread is a very important subject in options trading, as most strategies involve using them. There are many different types, and they are not all covered in this particular section. Instead, we have just covered the main categories, explaining their basic characteristics, and showing you how they can be used. We would suggest familiarizing yourself with the information in this section first, but for a more comprehensive list of the different types you can read our section on options trading strategies.

In that section we cover all the spreads you need to know with detailed information on how to use them. Types of Options Spreads The real benefits of options trading come with using options spreads. Section Contents Quick Links. Read more about Calendar Spreads Ratio This is applied to any spread that involves buying and selling differing amounts of options contracts, as opposed to buying an amount of contracts equal to the amount written.

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