What are call spreads and put spreads?
Call spreads and put spreads are options trading strategies. They are also known as vertical spreads, money spreads, or price spreads.
A call spread is when you buy one call option and sell another call option that has a higher strike price. The call option you buy lets you buy the underlying stock or asset at a certain price by a certain date. The call option you sell obligates you to sell the stock at the higher strike price if the option buyer chooses to exercise their option. Both options have the same expiration date.
A put spread is when you buy one put option and sell another put option that has a lower strike price. The put option you buy gives you the right to sell the underlying stock at a certain price by a certain date. The put option you sell obligates you to buy the stock at the lower price if the option is exercised. Again, both options expire on the same date.
Why do traders use call spreads and put spreads?
Traders like using call spreads when they think a stock price will go up a bit, but not by a huge amount. The call spread lets them profit if they’re right, but limits their losses if the stock doesn’t go up as much as they thought or even goes down.
Put spreads are used when traders think a stock will go down some but not massively. The put spread makes money if the stock drops to a certain point. But the trader doesn’t lose as much if the stock doesn’t drop or even goes up instead.
Both spreads cost less than just buying a call or put option outright. That’s because the money received from selling the other option in the spread offsets the cost of the long option.
An example of a call spread
Let’s say stock XYZ is trading for $50 a share. A trader can buy a $50 strike call option for $5 that expires in one month. Then they sell a $55 strike call also expiring in one month for $2.
Their total cost, or debit, for this call spread is: $5 (price of the long call) – $2 (money received for the short call) = $3
The most this call spread can make is $5. That’s the difference in strike prices ($55 – $50) minus the $3 cost. The trader makes $5 if the stock is trading above $55 when the options expire.
The most the trader can lose is $3, the cost of the spread. That happens if the stock is below $50 at expiration.
An example of a put spread
Using the same XYZ stock at $50, a trader could buy a $50 strike put expiring in one month for $3. At the same time, they sell a $45 strike put with the same expiration for $1.
The cost of this put spread is: $3 (cost of the long put) – $1 (money collected for selling the short put) = $2
The maximum profit on this spread is $3. That’s the $5 difference in strike prices ($50 – $45) minus the $2 cost. The trader earns this if XYZ is below $45 at expiration.
The max loss is the $2 total cost of the put spread. That happens if XYZ stays above $50.
The break-even points
Call spreads and put spreads have break-even points. That’s the stock price where the trade doesn’t make or lose any money.
For call spreads, the break-even is: The strike price of the long call plus the total cost of the spread
In our example, that’s $50 + $3 = $53
If XYZ is at $53 at expiration, the call spread breaks even. It makes money above that price and loses money below it.
For put spreads, the break-even is: The strike of the long put minus the cost of the spread
In the example, that’s $50 – $2 = $48
So the put spread doesn’t profit or lose at $48. It turns a profit below that level and loses money if the stock is above $48 at expiration.
The tradeoffs of spreads
Vertical spreads have pros and cons. The big benefit is they’re cheaper than buying just a call or put. The lower cost means the trader risks less money.
The tradeoff is their profit potential is capped. Even if the stock soars way past the short call’s strike price or plunges far below the short put’s strike, the spread has a fixed max gain.
Traders have to give up those big home run profits in exchange for lower risk. Spreads make more sense when traders expect a modest move in the stock rather than a huge shift.
Spreads and implied volatility
Implied volatility is a key options trading concept. It’s a measure of how much traders expect the stock to bounce around in the future. High implied volatility means they anticipate big stock moves. Low volatility points to smaller expected moves.
Spreads are impacted less by changes in implied volatility compared to long-only positions. That’s because the short option the trader sells is affected by volatility changes in the opposite way of the long option they buy.
Rising volatility helps long option positions but hurts short options. Falling volatility is bad for long options but good for short ones.
Since spreads have both long and short options, the volatility impacts tend to offset each other. This is another way spreads are less risky than outright long call or put positions.
Choosing strike prices and expiration dates
Traders have flexibility in setting up call and put spreads. They can widen or narrow the spread between the two strike prices. A wider spread means bigger potential profits but higher risk and cost. A narrower spread equals lower max gains but also limited losses.
The timing of the expiration date also matters. Shorter-term spreads are less expensive and prone to time decay. But they have less time for the expected stock move to happen. Longer-term spreads cost more but provide more time for the trade thesis to play out.
Traders weigh these factors based on their risk tolerance, profit goals, and market outlook. More aggressive traders may prefer wider spreads with more time until expiration for the chance at bigger gains. Conservative traders often choose narrower, shorter-term spreads to keep risk in check.
