Spreads 101

Level 1 to Level 3 options in one quick step

At Options AI, we are passionate about simplifying advanced trading. This includes how we approach more complex strategies.

Our unique fast-track approach to explaining spreads actually starts with a basic level 1 strategy familiar to most options traders. From there, we explain how it can be one quick step to understanding spreads. But first, let's do a general reminder of the case for selling as well as buying options.

The Case for Selling Options

We know that buying a Call (or Put) option means we will see potentially uncapped gains if the underlying stock moves above (or below) our breakeven at expiration. Breakeven being our options Strike Price plus (or minus) the Premium we pay to buy the option.

Premium (the 'price' or 'cost' of an option) reflects, amongst other things, implied volatility or the magnitude of move in the underlying stock expected by the options market. During periods of increased stock price volatility or around binary events such as earnings, options premiums may be elevated, leading to a larger Expected Move and higher (or lower) breakeven levels. But in all market conditions, it is the role of market makers and other options market participants to ensure that premiums accurately price future underlying stock moves.

It follows therefore, that in order to realize any profit when buying options, not only do we need to be right on direction, but we also typically need a magnitude of move greater than what the options market was pricing or expecting. In other words, we don’t just need to be right, we also need for the options market to have been wrong.

Therefore, as option buyers, we often accept a relatively low Probability of Profit (“PoP”) in return for the potential of outsized and uncapped gains.

Turning this on its head, if buying options typically means lower PoP, then selling options and collecting premium should mean higher PoP. While this generally holds true and therefore sounds compelling, it is important to remember that we are short rather than long options, we are also substituting our potential for uncapped gains with the potential for unlimited losses. Without defining our risk when selling options, when things go wrong, they can go very wrong.

The Case for Selling Options in a Spread

By reminding ourselves of the basic trade-offs in risk, reward and probability when either buying or selling options, we immediately get a sense of why, combining the respective advantages of both buying and selling options, might allow for something altogether smarter.

Spreads, or the simultaneous buying and selling of options to create multi-leg positions, are favored by institutional investors for this very reason. The opportunity to define risk, lower cost and improve probability of profit whether seeking income, leverage or protection from options.

Understanding Spreads: back to basics with the Covered Call

The Covered Call (or Buy-Write) is often regarded as one of the most basic and relatively low-risk option strategies. And yet it involves selling rather than buying options.

To setup a Covered Call, we sell a Call option, typically against a corresponding long position in the underlying stock, at Strike price above where the stock is currently trading.

If the stock price remains below our Strike at expiration, then we keep the total premium received from selling the Call. We apply this income to the overall rate of return on the stock (or see it as having boosted our yield). But if the stock moves up and through our breakeven (Strike Price + Premium received) then our upside potential in the stock is capped and we run the risk of being called-away. Since we know that selling options typically comes with a Probability of Profit greater than 50%, we are willing to accept these trade-offs with the goal of generating net income (profits) over time.

With the fundamentals of the Covered Call in mind, lets now apply two simple modifications to create Spread strategies.

From Covered Call to Debit Call Spread

To be very clear from the outset, the Debit (Bull) Call Spread is not an alternative to a Covered Call. The former is a directionally bullish strategy while the latter is a more passive income generating strategy. Yet for purposes of de-mystifying spreads, the comparison can be very useful.

Put simply, by replacing the long stock leg of a Covered Call with a long Call position (at a strike below our short call), we have immediately transitioned from level 1 options to level 3 spreads - without taking on a fundamentally different market risk profile.

The Covered Call allows us to participate in upside in the underlying stock, but caps our potential gains at the short (or Covered Call) strike level. The Debit Call Spread allows us to participate in stock price gains from our breakeven level (long strike price + premium paid) up to our short strike level. And, if the underlying stock price goes up and through our short Call strike, our long Call covers us in a similar way to how our long stock position covers us with a Covered Call.

Again, the purpose of this comparison is not to imply that these are interchangeable strategies or to suggest that spreads do not have unique risks (such as liquidity). It is simply designed to demystify the notion that spreads require a big leap in options knowledge and understanding.

From Covered Call to Credit Call Spread

We have seen how the setup of a Debit (Bull) Call Spread is conceptually very similar to a Covered Call. We are simply buying a Call option instead of buying underlying Stock. And, if we are comfortable with a Covered Call, we are already comfortable with the idea of selling, or being short, options.

So, for our first in-depth strategy review we stay with the theme of the Covered Call strategy as a starting point and look at how we can make another straightforward modification, this time to setup a Credit Call Spread.