You enter a spread by buying and selling an equal number of calls or puts on the same underlying, but with a different strike or expiration.
Spreads come in many variations. But there are some common features, like the combined positioning of offsetting calls, puts, or both, and in configurations both above and below the current value. This price cushion makes spreads attractive on both long and short sides.
The best way to analyze spreads, and to decide which one is a good match for you, is to study "profit zones" and "loss zones."
A long spread is constructed with a long call and a long put. Of course, you will pay a premium to own both. This sets up a "loss zone" in a middle range between the two strikes, and extending above and below those strikes the number of points paid for the options. If you open a long spread, you have to expect considerable price movement before expiration.
A short spread also creates income from selling both a call and a put. Your "profit zone" is created both above the top strike and below the bottom strike, equal to the premium you get when you open the short spread. So long as the underlying market price remains in between the strikes, there is no exercise risk. Even in the event of exercise within this range, of either option, the premium income covers you. However, if the underlying price moves above or below this middle-range profit zone, then it becomes a loss zone. And the farther it moves, the greater the loss.
On short spreads, you can mitigate or defer that loss zone by either closing one of the short positions, rolling forward, or covering the short (with stock purchase in the event of the short call, or in either case with a later-expiring long option). Spreads of this type - with the same expiration but different strikes - are called vertical spreads.
Horizontal spreads (also called calendar or time spreads) have the same strike but different expirations, and can be either long or short. I'll give you an example of one in the next chapter.
Spreads with different expiration and different strike are called diagonal spreads, and also can be either long or short.
Straddles are similar to spreads, but they have the same strike and expiration. What's especially appealing about straddles is, you can profit based on how much the underlying moves - regardless of the direction of the price movement.
A long straddle will have a middle-range loss zone extending both above and below the strike by the number of points you pay for the two options. If the underlying price moves above or below this middle loss zone before expiration, your profit zone is set up. Long straddles can also be timed to take advantage of volatile price swings in the underlying.
In a short straddle, the premium you get for selling the call and the put set up a profit zone extending from the strike, both above and below. The zone covers the same number of points as the premium you received. So if your total premium was 7 and your strike was 30, your profit zone extends from the high of $37 per share, down to $23 - a range of 14 points. If the underlying closes within this range, you earn a profit. Your breakeven prices, before deducting trading costs, are $37 and $23. If the underlying price moves above $37 or below $23 by expiration, you will have a loss.
The short straddle can avoid exercise on both sides. Either side can be rolled forward if the underlying price moves too far in the money (it will always be ITM on one side or the other).
It can also be closed. If time value has evaporated, even an ITM short option might be closed at a small profit. Or, as long as the price is within the profit zone, accepting exercise produces a net profit due to the combined premium income from selling the two options.
As you can see, options are amazing, versatile tools. They can be very speculative and high-risk and give you spectacular returns.
That's why we created our free investor guide, "The Power of Options" you can receive your free copy by clicking here.
Michael C. Thomsett is contributing options expert with Money Morning.