Option Spreads enable investors to make directional bets with limited funding amounts and limited risk. To execute a spread, an investor simultaneously buys and sells options (either calls or puts) on the same underlying stock at different strike prices. One reason for the multiple transactions is that selling one option can fund the other. Another reason is that buying one option can minimize risk exposed by the other.
When an investor has a bullish outlook, he can take a Bull Spread position by buying a call spread or selling a put spread; the payoffs are similar. Purchasing a call spread involves buying a call option and selling another call option at a higher strike price. Selling a put spread is selling a put option and buying another put option at a lower strike price.
(image from OptionsXpress)
When an investor has a bearish outlook, he can take a Bear Spread position by selling a call spread or buying a put spread; these payoffs are also similar to each other and are the mirror image of the bull spread. Selling a call spread involves selling a call option and buying another call option at a higher strike price. Buying a put spread is buying a put option and selling another put option at a lower strike price.
(image from OptionsXpress)
Bonus material…
Combining straddles and strangles, from Options – Neutral Strategies, with a spread, creates a Butterfly and Condor. The Butterfly is simply a straddle with a spread on each end; the Condor is a strangle with a spread on each end.
(image from OptionsXpress)
