Option Spread Trading
A spread is merely a position consisting of two components transacted simultaneously or in close succession where each position would profit from opposite directional price moves in the market. Each part of the paired spread is entered into simultaneously in the hopes of either limiting risk or obtaining benefit from the change in price relationship between them.
Spreads are of two types: - Directional & Volatility spreads.
A trader would use a Directional Spread when one is focusing on the underlying directional price movement (up or down). For this trader, the volatility in the market is of secondary importance, one rather wants to harness the bullish or bearish movement that one foresees happening. The first type of Directional Spread that is the 1:1 Vertical Spread. This simple combination gives a range of profitability with less risk than the outright purchase of a naked put or calls. The trader has put on a Vertical Spread when one has both purchased one option and sold another where both options are of the same type (call or put) and expiration (e.g. July) but have different strike prices.
A Bull Spread is a strategy involving two or more options that will result in a profit from a rise in price of the underlying asset. A Bull Spread would be implemented by an investor who was bullish on the underlying asset but who is not bullish enough to buy a call option straight out.
A Bear Spread is a strategy involving two or more options that will profit from a decrease in the price of the underlying asset. This investor is bearish about the underlying asset. One hopes to capitalize on what one foresees as a downward movement, but is somewhat more risk averse than the outright buyer of a put.
Bull Spreads and Bear Spreads are of two types. Bull Spreads can be either Call Bull Spreads or Put Bull Spreads, and Bear Spreads can be either Call Bear Spreads or Put Bear Spreads.
A Call Bull Spread consists of the purchase of one call option with a lower strike price and the sales of another call option with a higher strike price.
A Put Bull Spread consists of the sale of one put option with a higher strike price and the purchase of another put option with a lower strike price.
A Call Bear Spread consists of the sale of one call option with a lower strike price and the purchase of another call option with a higher strike price.
A Put Bear Spread consists of the purchase of one put option with a higher strike price and the sale of another put option with a lower strike price.
The trader who uses a volatility spread is chiefly interested in the degree of volatility of the underlying asset, and only secondarily in the directional movement of the underlying asset. Volatility can be defined as the measure of price fluctuation of the underlying asset. Now the Volatility Spreader may have a bullish or bearish perspective on the market, but unlike the Directional Spreader, one tries to take advantage of the fluctuation in market price of the underlying asset rather than bet on its direction.
Volatility spreads are sensitive to a number of factors, including the price of the underlying asset, time until expiration, price volatility, and prevailing interest rates. Volatility spreads are based on moves like "Buy a Call & Buy a Put at different strike prices" or "Sell a Call and Sell a Put at different strike prices" or a combination of various strategies to take advantage of price volatility of the underlying asset. There are a large variety of volatility spreading strategies including Straddles, Strangles, Back Spreads, Time or "Calendar" Spreads, Ratio Vertical Spreads, Butterfly Spreads and several others.