It is quite possible to profit from trading a single type of option trade, e.g. buying call options if one believes the price of the underlying asset will rise or buying put options if one believes it will drop between now and the expiration date. Options trading, however, has gained its legendary versatility exactly because one can combine different combinations of options in a unique mix that will profit from virtually any type of market condition.
Option spreads are the combination of buying and selling options of the same type on the same underlying asset, but with different expiration dates and/or strike prices.
Debit spreads and credit spreads
All option spreads fall into one of two categories: they are either debit spreads or credit spreads. In the case of a debit spread the trader has to pay an upfront premium to enter the spread. This would, for example, happen if one buys call options with a strike price that is nearer the money and simultaneously sells call options with a strike price that is further away from the money.
A debit spread normally carries limited risk – the trader cannot lose more than the initial premium paid.
In the case of a credit spread, the trader receives a net premium paid into his account when he or she enters the trade. This is normally because options with a higher premium value are sold and simultaneously options with a lower premium value are bought, as is the case with a bear call credit spread or a bull put credit spread.
Many credit spreads have a limited profit potential and an unlimited loss potential, for example the call ratio spread or the put ratio spread. The high probability of success with many of these trades, however, often compensates for their unfavourable risk profiles.
Bull and bear spreads and neutral spreads
Options spreads can also be categorised depending on whether they attempt to profit from a rising market, a falling market or a stagnant market. Bull spreads, such as the Bull Call Spread, seeks to profit from a prise increase in the underlying asset. Bear spreads, such as the Bear Call Spread, try to profit from a decline in the market. Neutral spreads, such as the Iron Butterfly and the Short Straddle, try to cash in on a price that remains either stagnant or within a narrow range.
These categories are not absolute: there are strategies that will work whether the market stays within a range, declines or goes up within a certain limit. An example is the call ratio spread.
With a calendar spread a trader combines options of the same type and often the same strike price, but different expiration dates. These trades generally try to benefit from the difference in time decay between longer term and shorter term options – a subject which will be discussed in more depth in another article.
There are literally hundreds of different types of options spreads, some carrying the names of exotic birds such as the Iron Albatross Spread. To trade options successfully it is not necessary to memorise all of them: it is necessary, however, to understand all of them in order to know what type of spread works best in a particular market condition.