Option spreads involve taking opposite positions at different strike prices to minimize risk. Vertical spreads involve a long and short option, while proportion spreads involve buying and selling different numbers of options. Butterfly spreads involve options at three different strike prices, and iron butterflies combine bullish and bearish spreads. Calendar spreads involve options with different maturities.
Option spreads are option trading strategies that involve taking simultaneous opposite positions at different strike prices or strike prices. Option pricing involves estimates regarding future volatility; Option spreads are a useful tool to minimize the risk of making incorrect estimates.
The simplest option is vertical. A vertical consists of a long and a short option. Both must have the same expiration date, but will have different strike or exercise prices. Depending on which strikes are being bought and sold, a vertical can be bearish or bullish. Selling (or buying) a lower priced put (or call) option while buying (or selling) a higher priced option is bullish; Taken in reverse, the vertical will be bearish. Vertical option spreads have limited risk but limited profit potential.
Proportion spreads, or spreads, are option spreads similar to vertical spreads, except that the number of options bought is not the same as the number of options sold. For example, a bull spread can be built by selling a lower-priced call and buying double the higher-priced calls. If the price moves dramatically higher, the spread will be profitable. Due to the reliance on rapid price movement, backspreads are classified as a volatility spread.
The butterfly strategy is a more complex option spread built from options bought and sold at three different strike prices. The three positions (legs) are of the same type; either all puts or all calls, and all with the same expiration date. If the underlying stock is at 100, a long butterfly could be made by buying put (or call) at 95 and 105 and selling double the put (or call) at 100. The maximum profit is made if the underlying stock is at 100 at expiration, and the maximum loss occurs if the price exceeds 95 or 105. This is, in effect, volatility shorting. A short butterfly reverses the buys and sells and, conversely, the maximum profit occurs if the price moves as far as possible from 100. It is a bet on increased volatility.
A related option spread can be constructed by combining a bullish spread (or put) with a bearish spread. If the two spreads are centered at the same price, for example, a short put at 95, a long put and long call at 100, and a short call at 105, it is called an iron butterfly. In terms of profit and loss potential, it acts much like a basic butterfly strategy. If the two spreads do not overlap, the position is called a condor.
All of the above option spreads involve positions with identical expiration dates. The calendar, or time difference, involves multiple positions with different maturities. A long-term spread involves selling one option and buying another at the same strike price but expiring at a later date. Like a long butterfly, it is a bet against rising volatility. A short period of time is the opposite; By selling the longer option, the position is sensitive to increases in volatility.
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