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What is an Option Spread?

Definition: An option spread is an options strategy that requires the opening two opposite positions to hedge against risk. With an options spread strategy, investors buy and sell the same number of options on an underlying asset, but at a different strike price and maturity.

What Does Options Spread Mean?

What is the definition of options spread? An options spread is defined based upon the relationship between the strike price and maturity. There are a few different types of spreads. Here are the main ones.

The horizontal spreads are option contracts on an underlying asset with the same strike prices, but different maturity.

The vertical spreads are option contracts on an underlying asset with the same maturity, but different strike prices.

The diagonals spread are option contracts on an underlying asset with different strike prices and maturity.

Furthermore, with a bull spread investors earn a profit if the stock price rises above the strike price, whereas, with a bear spread, investors earn a profit if the stock price falls below the strike price.

Finally, with a credit spread, investors earn a profit if the premium of the sold options is higher than the premium of the purchased options, whereas, with a debit spread, investors earn a profit if the premium of the sold options is lower than the premium of the purchased options. All options spread strategies can be constructed using calls or puts.

Letís look at an example.

Example

Kim is bullish on a technology stock that trades at $120. Because it is too expensive to buy 100 shares of the stock, she decides to buy a bull call spread on the stock to hedge the risk and acquire the stock at a lower price. Therefore, she buys a bull call spread for $2.20, paying $220.

How can Kim profit from the bull call spread?

Kim believes that the stock price will rise to $125 before maturity. So, she buys a call option at a strike price of $120 and a call option at a strike price of $125. The $120 call gives Kim the right to buy the underlying asset at the strike price of $120 and the $125 obligates Kim to sell the underlying asset at the strike price of $125. By buying one call option and selling the other call option, Kim is hedging the risk.

If the stock price rises, above $120, both legs of the bull spread will rise as well. Kim will make a profit from buying the underlying asset at the strike price of $120 and selling it at the strike price of $125, thus realizing a profit of $5 x 100 shares = $500 - $220 = $280.

Summary Definition

Define Options Spread: An option spread is an investment strategy used to mitigate risk by purchasing options at different strike prices with the spread being the range of potential earnings.

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