Spread strategies are more complicated than buying or selling a put or a call because they involve entering two or more options transactions on the same underlying stock or index. Typically, you'll buy one option and sell another. With a vertical spread, the options - known as the legs of the spread - will have different strike prices but the same expiration. The difference between the higher strike price and the lower one is the spread. With a calendar spread, it's the expiration months that will differ.
Vertical Credit Spread
In a vertical spread, if you receive more money for the option you write than you spend for the one you buy, you've opened a credit spread. Most investors employ this strategy with the hope that both options will expire out-of-the-money, leaving them with the credit as profit from the transaction.
For example, if stock NRQ is trading at $55, suppose you buy a call with a strike price of $65 for $1.50, and simultaneously write a call with a strike price of $50 for $5.50. If the stock's price falls to $49 by expiration, your profit is the difference between the two premiums, or $4 ($400).
And, if the price of the stock rises above both strike prices, you can close both of the positions. You can use the money you collect from selling your in-the-money long position to help offset the cost of your in-the-money short position.
Vertical Debit Spread
Alternatively, if you pay more for the option you buy than you collect from the option you sell, you've opened a vertical debit spread. In most cases, the goal of a debit spread is to have the stock move beyond the strike price on the short option so that you realize the maximum value of the spread.
For example, if you purchase a NRQ 20 call for $3 and sell a NRQ 25 call for $2, you start out with a net debit of $100. If the stock's price rises above $25, you'll end up with a profit. If the price reaches $30 at expiration, for instance, both calls will be in-the-money. You'll pay $2,000 for the shares if you exercise, but will receive $2,500 for the shares you sell, leaving you with a $500 profit. When you take into account your $100 net debit, you'll be left with a $400 net profit from the strategy.
Although spread strategies aren't always aggressive, they are complex and aren't appropriate for all investors. And, you might need to qualify at your brokerage firm before you can employ such a strategy. Even if you are eligible, you should be sure you're ready to take on the challenge of managing the two positions as expiration nears because it can require significant time and attention.
Common Spread Strategies
The two graphs shown here depict two common spread strategies, the bull call spread and the bear put spread. As their names suggest, investors generally use these in bullish and bearish markets, respectively.
Bull Call Spread
Bear Put Spread
In the graphs shown here, the vertical (Y-axis) represents profit and loss, while the horizontal (X-axis) shows the price of the underlying stock. The blue line shows your potential profit or loss given the price of the underlying.
Examples exclude transaction costs and tax considerations.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting