Gold Options Explained

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Options Expiration Explained

Options can be dangerous.

They have a time limit.

That’s completely different than how stocks trade.

So if you’re going to trade options, you’re going to have to master the ins and outs of options expiration.

This guide will answer every single question

Why Options Expiration (OpEx) is So Important

If you come from a directional trading background (meaning long or short), then you probably only focus on where a stock or market is going.

But that is only one part of the option trading equation. It’s known as delta.

The true risks in the options market come from two things:

Theta – the change of an option price over time

Gamma – your sensitivity to price movement

A failure to understand these risks mean that you’ll put your portfolio in danger. especially as options expiration approaches.

If you’re in the dark about the true mechanics of options expiration, make sure you read this before you trade another option.

How Does Options Expiration Work?

When it comes down to it, the financial market is all about contracts.

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If you buy a stock, it’s basically a contract that gives you part ownership of a company in exchange for a price.

But options are not about ownership. It’s about the transfer or risk.

It’s a contract based on transactions.

There are two kinds of options, a call and a put.

And you have two kinds of participants, buyers and sellers.

That leaves us with four outcomes:

If you’re an option buyer, you can use that contract at any time. This is known as exercising the contract.

If you’re an option seller, you have an obligation to transact stock. This is known as assignment.

On the third Saturday of the month, if you have any options that are in the money, you will be assigned. This process is known as “settlement.”

The transaction in these options is handled between you, your broker, and the Options Clearing Corporation. You never will deal directly with the trader on the other side of the option.

If you are long options that are in the money, you will automatically begin the settlement process. If you don’t want this to happen, you will have to call your broker.

Why don’t Out of the Money Options get assigned?

Each option has a price that the buyer can buy or sell the stock– this is known as the strike price.

If it is “cheaper” to get the stock on the market, then why would you use the option?

If the stock is trading at $79, which makes the most sense.

Buying the stock on the market at $79?

Or using the option to buy the stock at $80?

The first one, of course.

So into expiration, these out of the money options will expire worthless.

What are the Options Expiration Dates?

Technically, expiration occurs on Saturday. That’s when settlement actually occurs. But since the market’s don’t actually trade on Saturday, we treat Friday as the effective expiration date.

For monthly option contracts, the expiration is the Third Friday of each month.

With the introduction of weekly options into the mix, we now have options that expire every single Friday.

The CBOE has a handy calendar that you can download and print for your desk.

Are There Exceptions?

There’s a handful of “goofy” expiration dates on specific options boards.

For monthly SPX options, they stop trading on Thursday, and the settlement value is based on an opening print Friday morning. These contracts are “cash settled” meaning there is no true assignment but instead you look at the intrinsic value of the options and convert it into cash.

Here’s where it can get weird. SPX weekly options are settled on Friday at the close. So if you are trading around OpEx with the SPX you need to check if it’s a weekly or monthly contract.

How do options trade at expiration?

When we look at options pricing, we generally follow a traditional model. We can look at the things that affect the options pricing, known as the greeks.

But when the market heads into options expiration, weird things can happen.

It’s very similar comparing traditional particle physics with what happens at the quantum level.

There’s a concept that I call the “gamma impulse.”

If you look at a call option into expiration, it has this risk profile:

Yup. It’s a Call Option.

We know that if the option is out of the money, it will have no directional exposure (0 delta), and if the option is in the money it will behave like stock (100 delta).

notice two different values for delta

The gamma of an option is the change of the delta relative to price.

So there is this discontinuity right at the strike price– and the gamma of the option can be represented by a “dirac function.” This is what I call a gamma impulse.

don’t get caught on the wrong side of this.

If you have an option that switches from OTM to ITM very quickly, your risks change drastically.

What if I don’t have enough cash to cover assignment?

This is where it gets interesting.

And this is why you need to be extra vigilant into expiration.

If you have a short option that goes in the money into expiration, you must fulfill that transaction.

If you don’t have enough capital, you will get a margin call on Monday.

You also have gap risk.

This happened to me back in 2007.

I had a pretty decent-sized iron condor in BIDU.

This was back before their 10:1 split.

I found on Saturday that the short options had expired in the money, and that I now had a sizeable long position on in BIDU.

Not Fun.

I was lucky enough to see BIDU gap up the following Monday and I exited for a gain.

But. never again. Make sure your books are cleared out of all in the money options if you don’t want to get assigned.

What if I’m short a call without stock?

If you have a sold call, you will be given a short position if you don’t own the stock already. This is known as a “naked” call rather than a “covered” call.

Margin to hold this short is determined by your broker, and to eliminate the short you will have to “buy to close” on that stock.

What about options pinning?

See my full guide on options pinning.

Can You Get Assigned Early?

There are two types of options: American and European.

With European-style options, you can’t get assigned early.

With American-style, you can get assigned whenever the option buyer feels like it.

Most options are American style, but you rarely have early assignment.

What if I don’t want to get assigned?

So you’re coming into options expiration with short options that are in the money.

And you don’t want to be short the stock or own the stock.

  • Solution #1: Never get down to options expiration with in the money options. Be proactive with your trades.
  • Solution #2: Close out the in the money option completely. This may be difficult into options expiration as the liquidity will dry up and you will be forced to take a worse price.
  • Solution #3: Roll your option out in time or price. These kinds of rolls, as detailed in my options trading course, will move your position into a different contract that has more time value, or is out of the money. These are known as calendar rolls, vertical rolls, and diagonal rolls.

A good rule of thumb is if your option has no extrinsic value (time premium) left, then you need to adjust your position.

How To Make Money Trading Around Expiration

Because of that “gamma impulse” we talked about earlier, the risks and rewards are much, much higher compared to normal options tarding.

There’s two groups of OpEx trades to consider: option buying strategies and option selling strategies.

Option buying strategies attempt to make money if the underlying stock sees a faster move than what the options are pricing in. The profit technically comes from the delta (directional exposure), but since it is a long gamma trade, your directional exposure can change quickly leading to massive profits in the very short term. The main risk here is time decay.

Option selling strategies attempt to make money if the stock doesn’t move around that much. Since you are selling options you want to buy them back at a lower price. And since option premium decays very fast into OpEx, the majority of your profits come from theta gains. Your main risk is if the stock moves against you and your directional exposure blows out.

Options Expiration Trading Strategy Examples

We do trade around OpEx at IWO Premium. Here are some of the strategies we use:

Weekly Straddle Buys

This is a pure volatility play. If we think the options market is cheap enough and the stock is ready to move, we will buy weekly straddles.

As an example, a trade alert was sent out to buy the AAPL 517.50 straddle for 5.25. If AAPL saw more than 5 points of movement in either direction, we’d be at breakeven. Anything more would be profit.

The next day, AAPL moved over 9 points, leading to a profit of over $400 per straddle:

This trade is risky because it has the opportunity to go to full loss in less than 5 days. Position sizing and aggressive risk management is key here.

Spread Sale Fades

When an individual stock goes parabolic or sells off hard, we will look to fade the trade by either purchasing in-the-money puts or by selling OTM spreads.

With the market selling off hard in December and the VIX spiking up, premium in SPX weeklies were high enough to sell them. So a trade alert was sent out to sell the SPX 1750/1745 put spread for 0.90:

Once the risk came out of the market, we were able to capture full credit on the trade.

Lotto Tickets

These are high-risk, high-reward trades that speculate strictly on the direction of a stock. Generally a stock will develop a short term technical setup that looks to resolve itself over the course of hours instead of days. Because of that short timeframe, we’re comfortable with buying weekly calls or puts. These trades are made in the chat room only, as they are fast moving and very risky.

These are just some of the trades we take within the IWO Premium Framework. If you feel that it’s a right fit for you, come check out our trading service.

Gold, Explained

Gold often comes into the limelight when there is heightened geopolitical risk because it is viewed as a store of value during volatile times. Yet the gold market and the various methods to access gold are quite nuanced. The following analysis seeks to shed light on gold by answering four key questions:

  • How does the gold supply chain work?
  • What are the main sources of demand for gold?
  • What is the outlook for the supply and demand balance?
  • What are the key differences between the various ways to access gold?

How does the gold supply chain work?

Gold is a rare element, with an average concentration of just 0.005 parts per million. In other words, just 1 gram of gold can be extracted from 250 tons of ordinary gravel. 1 Given its scarcity, it is seldom found in concentrations that make extraction economically viable. In order to support a profitable mining project, gold explorers conduct geological surveys targeting concentration levels that are 1000 times higher than normal. After discovering an ore, geologists and engineers will engage in a feasibility study to determine whether the project has economic value, prior to the commencement of any mining operations. They will also seek approvals from the appropriate governing bodies, including local governments and environmental agencies, to proceed with the mining project.

The next phase focuses on efficiently extracting gold from other natural materials in the mine. There are two processes for doing so: milling and amalgamation. Milling is a chemical process whereby the ore is ground into a fine powder and mixed with water to form a slurry. This slurry is then passed through a carbon-in-leach circuit, which attaches the gold particles to carbon, separating it from other materials. 2 In amalgamation, gold ore is dissolved in mercury and then the mercury is distilled away. 3 Once the gold is purified, it is smelted and pressed into gold bars to be sold in the market.

A more detailed look at the mining life cycle can be found in the chart below.

What are the main sources of demand for gold?

Jewelry: Until relatively recently, jewelry constituted the vast majority of all gold demand. To this day, gold jewelry remains one key source of demand for the precious metal.

Investing: Gold has gained popularity as an alternative asset class that can potentially hedge against inflation and geopolitical risks. Holding gold directly though physical ownership of bars and coins or indirectly through investment vehicles like ETFs and futures are popular ways of gaining exposure to gold.

Central Bank Reserves: Central banks are net buyers of gold. They often fill up their treasuries with gold bullion, which serves as a reserve. This circumstance is partly due to changes in banking regulations, which as a result of Basel III now classify gold as a tier I asset (a primary measure regulators use to evaluate a bank’s financial health).

Currency: Gold continues to be used as a form of non-fiat currency around the globe, particularly in underdeveloped economies which struggle with high inflation.

Industrial: Gold’s malleability, conductivity, and non-reactivity make it a useful component for a variety of applications, including personal electronics, medicine, and aeronautics, among other uses. 4

What is the outlook for the supply and demand balance?

Some commodities, like oil, can demonstrate rapid changes in supply due to changes in spot prices. Gold production, however, has been relatively insensitive to changes in gold spot prices compared to other natural resources. This phenomenon is largely due to the geological challenges that prevent a rapid increase in production. For example, the gold mining industry already faces challenges with the depletion of existing mines and fewer new discoveries, which constrains supply growth. Additionally, increased government and environmental regulations, higher production costs, and falling ore quality, can constrain supply growth. Gold supply constraints have temporarily eased, and production is expected to increase through 2022, backed by higher gold prices and mine investments, boosted by stronger company financials.

Actual supply and demand numbers, however, can change rapidly. The major factors expected to drive supply and demand trends in 2020 include:

    • Geopolitical Risks: With perceived political risks increasing worldwide, demand for gold could increase as investors look for store of value assets in times of uncertainty. We believe the U.S.-China trade war poses the biggest risk. Middle East politics, new dynamics in the U.S.-Saudi relationship and their potential impact on the oil market, uncertainties surrounding Brexit, and an outburst in European populism also remain as risks.
    • Equity Market Risks: In 2020, U.S. equities performance was at a 10-year low, and the market remained highly volatile on concerns about a global slowdown, the Federal Reserve’s (Fed) rate tightening, and inflation fears. 5 In these times of volatility, investors could look to diversify away from equity and increase exposures into low-correlated assets like gold.
    • Weakening U.S. Dollar: U.S. dollar appreciation in 2020 is expected to reverse in 2020 and 2020, and this could possibly make gold a more preferred investment option. With the Fed unlikely to hike interest rates much higher in 2020 and U.S. growth moderating, factors that strengthened the currency are weakening. The U.S.’s high current account and fiscal deficit would also put pressure on the currency. 6,7,8
    • Rising Debts and Deficits: The world has become very indebted, with debts surpassing pre-financial crisis levels. According to recent estimates by Bureau of International Settlement, global debt stood at 217% of GDP. Further, the U.S. budget is increasing and is estimated at 6% of GDP in 2020, a level generally not seen during a period of high growth. These high levels of debts and deficits pose a threat, especially as interest rates are rising. Gold as a real asset can act as a hedge against these rising debts. 9
    • Central Bank Demand: Central banks continued to increase their gold purchase in 2020, reaching the highest annual pace since 2020. Emerging markets, which generally have a small portion of reserves in gold, were ardent purchasers of the yellow metal during the year. This trend is expected to continue in 2020, particularly in China, Russia, and Turkey, and new central banks are expected to focus on gold purchase. 10
    • New Technological Trends: Gold is a component of almost every electronic piece. New technological trends, like the adoption of the Internet of things and shift to hybrid and autonomous vehicles, should lead to an explosion in the sale of electronic goods and components, boosting the demand for gold. 11
    • Supply Constraints: Though supply constraints have temporarily eased and gold production is expected to increase through 2022, in the long run, supply will be constrained by increasing operational costs and inadequate gold discoveries. 12,13

What are the key differences between the various ways to access gold?

There are a variety of methods for gaining exposure to gold, each of which has different characteristics with respect to its correlation to gold prices, fees, taxation, and liquidity.

Segmenting the Gold Equities space

Gold mining companies are distinguished by their role in the supply chain and size.

Explorers

Explorers begin operations at the earliest stage in the discovery process. These companies look to evaluate potential exploration projects, electing to use their expertise and scientific due diligence processes to strategically purchase assets. Often, explorers may have the rights to only a handful of projects. Once gold has been discovered, explorers can elect to engage in M&A activity with a mining company or undergo the mining phase themselves. These companies’ economic success are often tied to their ability to successfully find economically feasible gold ores as well as changing prices in gold. Companies that explore are sometimes equated with venture capital in that investments in gold exploration companies are early stage, high risk, with high potential reward.

Junior Miners

Junior Miners are smaller-sized companies that can be involved in a variety of stages of the gold cycle, including exploration, development, or mining. They are primarily defined by their size, which can make these companies more nimble and more able to pursue smaller opportunities that are overlooked by larger mining firms. These smaller firms can also have higher risks than larger mining companies, as smaller firms tend to have less efficient operations, less access to capital, and fewer mining projects in their portfolios.

Larger Miners

Larger mining firms tend to own a variety of gold projects around the world and have greater access to the capital markets through debt and equity issuances. While these firms can sometimes lower their costs through economies of scale and operational efficiency, they tend to be dependent on acquisitions of new mining projects to grow their production. Therefore, these firms ultimately depend on explorers and junior miners to grow.

Gold Jun ’20 (GCM20)

Stocks: 15 20 minute delay (Cboe BZX is real-time), ET. Volume reflects consolidated markets. Futures and Forex: 10 or 15 minute delay, CT.

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The Futures Options Quotes page provides a way to view the latest Options using current Intraday prices, or Daily Options using end-of-day prices.

Options prices are delayed at least 15 minutes, per exchange rules, and trade times are listed in CST.

Options Type

American Options: An American option is an option that can be exercised anytime during its life. American options allow option holders to exercise the option at any time prior to, and including its maturity date, thus increasing the value of the option to the holder.

European-Style Options: A European option is an option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes trade at a discount to their comparable American option because American options allow investors more opportunities to exercise the contract.

Short Dated New Crop Options: The term short-dated refers to a shorter window before the option’s last trading day, otherwise known as option expiration. A traditional (or long-dated) option has a longer window before the option expires. In corn, traditional December calls and puts expire in late November. In soybeans, traditional November calls and puts expire in late October. Short-dated options have the same underlying futures contract (or instrument). The underlying futures contract for corn is December, and the underlying futures contract for soybeans is November. With short-dated, there are fewer days of coverage. As an example, a July short-dated option will expire in late June, even though the underlying futures contract is December.

Calendar Spread Options: A calendar spread is an option spread established by simultaneously entering a long and short position on the same underlying asset but with different delivery months. Sometimes referred to as an interdelivery, intramarket, time or horizontal spread.

Weekly Options: Weekly options are the same as standard American Options, except they expire on a Friday.

  • Week 1 options expire on the first Friday of the month
  • Week 2 options expire on the second Friday of the month
  • Week 3 options expire on the third Friday of the month
  • Week 4 options expire on the forth Friday of the month
  • Week 5 options expire on the fifth Friday of the month (if it exists)

Weekly European Options: Same as Weekly Options above but can only be exercised at the maturity date (Friday).

Monday Weekly Options: A weekly option that expires on Monday rather than Friday.

  • Week 1 – 1st Friday of the month
  • Week 2 – 2nd Friday of the month
  • Week 3 – 3rd Friday of the month
  • Week 4 – 4th Friday of the month
  • Week 5 – 5th Friday of the month

Wednesday Weekly Options: A weekly option that expires on Wednesday rather than Friday.

  • Week 1 – 1st Wednesday of the month
  • Week 2 – 2nd Wednesday of the month
  • Week 3 – 3rd Wednesday of the month
  • Week 4 – 4th Wednesday of the month
  • Week 5 – 5th Wednesday of the month

New Crop Options: Options with an expiration date after harvest has been completed.

CSO Consecutive: A calendar Spread where the first leg is the front month and the second leg is the next available month.

Average Price Options: A type of option where the payoff depends on the difference between the strike price and the average price of the underlying asset. If the average price of the underlying asset over a specified time period exceeds the strike price of the average price put, the payoff to the option buyer is zero. Conversely, if the average price of the underlying asset is below the strike price of such a put, the payoff to the option buyer is positive and is the difference between the strike price and the average price. An average price put is considered an exotic option, since the payoff depends on the average price of the underlying over a period of time, as opposed to a straight put, the value of which depends on the price of the underlying asset at any point in time.

Crack Spreads: The spread created in commodity markets by purchasing oil options and offsetting the position by selling gasoline and heating oil options. This investment alignment allows the investor to hedge against risk due to the offsetting nature of the securities.

Crack Spread Average Price Options: Similar to Crack Spreads above, but use Average Price options.

MidCurve Options: Eurodollar Mid-Curve options are short-dated American-style options on long-dated Eurodollar futures. These options, with a time to expiration of three months to one year, have as their underlying instrument Eurodollar futures one, two, three, four or five years out on the yield curve.

Weekly 1-Year Options: Similar to MidCurve options, but expire in 1 weeks.

Weekly 2-Year Options: Similar to MidCurve options, but expire in 2 weeks.

Weekly 3-Year Options: Similar to MidCurve options, but expire in 3 weeks.

EOM Options: End Of Month options are designed to expire on the last business day of each calendar month, offering alignment with month-end accounting cycles.

Additional Selection Criteria

Select an options expiration date from the drop-down list at the top of the table, and select “Near-the-Money” or “Show All’ to view all options.

You can also view options in a Stacked or Side-by-Side view. The View setting determines how Puts and Calls are listed on the quote. For both views, “Near-the-Money” Calls are Puts are highlighted:

  • Near-the-Money – Puts: Strike Price is greater than the Last Price
  • Near-the-Money – Calls: Strike Price is less than the Last Price
Data Shown on the Page

For the selected Options Expiration date, the information listed at the top of the page includes:

  • Options Expiration: The last day on which an option may be exercised, or the date when an option contract ends. Also includes the number of days till options expiration (this number includes weekends and holidays).
  • Price Value of Option Point: The intrinsic dollar value of one option point. To calculate the premium of an option in US Dollars, multiply the current price of the option by the option contract’s point value. (Note: The point value will differ depending on the underlying commodity.)
Stacked View

A Stacked view lists Puts and Calls one on top of the other, sorted by descending Strike Price. Puts are identified with a “P” after the Strike Price, while Calls are identified with a “C” after the Strike Price.

  • Strike: The price at which the contract can be exercised. Strike prices are fixed in the contract. For call options, the strike price is where the shares can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying contract’s current market price and the option’s strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid.
  • Open: The open price for the options contract for the day.
  • High: The high price for the options contract for the day.
  • Low: The low price for the options contract for the day.
  • Last: The last traded price for the options contract.
  • Change: Today’s change in price
  • Volume: The total number of option contracts bought and sold for the day, for that particular strike price.
  • Open Interest: Open Interest is the total number of open option contracts that have been traded but not yet liquidated via offsetting trades for that date.
  • Premium: The price of the options contract.
  • Time: The time of the last trade for the options contract.
Side-by-Side View

A Side-by-Side View lists Calls on the left and Puts on the right.

  • Last: The last traded price for the options contract.
  • Volume: The total number of option contracts bought and sold for the day, for that particular strike price.
  • Open Interest: Open Interest is the total number of open option contracts that have been traded but not yet liquidated via offsetting trades for that date.
  • Premium: The price of the options contract.
  • Strike: The price at which the contract can be exercised. Strike prices are fixed in the contract. For call options, the strike price is where the shares can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying contract’s current market price and the option’s strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid.
Totals

The totals listed at the bottom of the page are calculated from All calls and puts, and not just Near-the-Money options.

  • Put Premium Total: The total dollar value of all put option premiums.
  • Call Premium Total: The total dollar value of all call option premiums.
  • Put/Call Premium Ratio: Put Premium Total / Call Premium Total
  • Put Open Interest Total: The total open interest of all put options.
  • Call Open Interest Total: The total open interest of all call options.
  • Put/Call Open Interest Ratio: Put Open Interest Total / Call Open Interest Total.

Options Spreads Explained – A Complete Guide

Every options trader should know what options spreads are and what different types of options spreads exist. If you aren’t completely familiar with options spreads, this article will definitely help you out! After reading this article, you won’t only know what an options spread is. You will also be familiarized with all the different options spreads that exist. This is very powerful because if you fully understand options spreads, you will understand ALL options strategies!

So without further ado, let’s get started.

What Is An Option Spread?

Before we get into the different kinds of options spreads that exist, it is important to understand what an options spread even is. So what is an option spread?

An options spread is an option strategy involving the purchase and sale of options at different strike prices and/or different expiration dates on one underlying asset. An options spread consists of one type of option only. This means that options spreads either solely consist of call or put options, not both. Furthermore, an options spread has the same number of long as short options.

Let me give you a concrete example to make it clear what an options spread is. The following position is an options spread:

  • 1 XYZ short call with a strike price of 100 that expires in 40 days.
  • 1 XYZ long call with a strike price of 105 that expires in 40 days.

As you can see, the just-described options only differ in regards to strike price and opening transaction (one call option is bought and the other one is sold).

Let’s recap the characteristics of an options spread:

  • All involved options are on the same underlying asset (e.g. XYZ).
  • All involved options are of the same type (call or put).
  • An options spread always consists of the same number of purchased as sold options (e.g. 5 short and 5 long).

In other words, the options involved in an options spread only differ in regards to strike price and/or expiration date. This is the case for all options spreads, regardless of kind. So when I will walk you through all the different options spreads in a few moments, keep this in mind.

Even though the options involved in an options spread only differ in regards to 1-2 aspects, it is still possible to create a wide variety of different options spreads.

Next up, I will walk you through all the different kinds of options spreads: vertical spreads, horizontal spreads, diagonal spreads, credit spreads, debit spreads, bull spreads…

Option Spreads Visually Explained

Watch the following video for a visual breakdown of option spreads:

Different types of options spreads explained

What are vertical spreads?

Vertical spreads are options spreads created with options that only differ in regards to strike price. So basically, a vertical spread consists of the same number of short calls as long calls or the same number of long puts as short puts with the same expiration date (on the same underlying asset).

This doesn’t leave too many possibilities. That is also why only four different vertical spreads exist, namely bull call spreads, bear call spreads, bull put spreads and bear put spreads.

These four different vertical spreads can be ordered into different categories:

  • Bull Spreads: Bullish spreads (that profit from increases in the underlying asset’s price).
  • Bear Spreads: Bearish spreads (that profit from decreases in the underlying asset’s price).
  • Call Spreads: Spreads that consist of call options only.
  • Put Spreads: Spreads that consist of put options only.
  • Credit Spreads: Spreads that are opened for a credit (you get paid to open).
  • Debit Spreads: Spreads that are opened for a debit (you pay to open).

A bull call spread is a bullish debit spread, whereas a bear call spread is a bearish credit spread. A bull put spread is a bullish credit spread and a bear put spread is a bearish debit spread.

Here is how the four different vertical spreads are set up:

Bull Call Spread (aka. Long Call Spread):

  • 1 long call
  • 1 short call at a higher strike price (with the same expiration date)

Bear Call Spread (aka. Short Call Spread):

  • 1 short call
  • 1 long call at a higher strike price (with the same expiration date)

Bull Put Spread (aka. Short Put Spread):

  • 1 long put
  • 1 short put at a higher strike price (with the same expiration date)

Bear Put Spread (aka. Long Put Spread):

  • 1 short put
  • 1 long put at a higher strike price (with the same expiration date)

All vertical spreads are defined risk and defined profit strategies which means that you can’t lose or profit more than a certain amount. The amount of risk and potential profit depends on the width of the strikes and on the position of the strikes in relation to the underlying’s price.

To calculate the max risk and max profit of vertical spreads, you need one calculation:

Width of Strikes × 100 − Net Credit or Debit

This calculation reveals the max risk of credit spreads (Bull Put Spreads and Bear Call Spreads) and the max profit of debit spreads (Bear Put Spreads and Bull Call Spreads).

The max profit of credit spreads equals the net credit collected to open, whereas the max risk of debit spreads equals the net debit paid to open.

Vertical spreads are directional strategies which means that they mainly profit from price movement in the underlying asset’s price. That’s also why they are called bull/bear spreads. This means that vertical spreads are a strategy principally used to take advantage of price movement. Nevertheless, implied volatility and time still can influence vertical spreads to a certain extent.

What are horizontal spreads?

Horizontal spreads are options strategies that consist of the same number of long as short options that only differ in regards to the expiration date (on the same underlying asset). In other words, the options involved have the same strike price but a different expiration date.

Let me give you a concrete example to explain what a horizontal spread is:

  • 1 long ABC call with a strike price of 50 that expires in 29 days (front-month).
  • 1 short ABC call with a strike price of 50 that expires in 57 days (back-month).

Just like with vertical spreads, there only exist four different kinds of horizontal spreads, namely short call calendar spreads, long call calendar spreads, short put calendar spreads and long put calendar spreads. As you may have noticed, all of these spreads are calendar spreads. That is also the reason why horizontal spreads also are referred to as calendar spreads.

The setup of these four different calendar spreads is relatively simple:

Long Call Calendar Spread:

  • 1 short call (front-month)
  • 1 long call at the same strike price (back-month)

Short Call Calendar Spread:

  • 1 long call (front-month)
  • 1 short call at the same strike price (back-month)

Long Put Calendar Spread:

  • 1 short put (front-month)
  • 1 long put at the same strike price (back-month)

Short Put Calendar Spread:

  • 1 long put (front-month)
  • 1 short put at the same strike price (back-month)

Calendar spreads are mainly used as a strategy to profit from changes in implied volatility and from time decay. For instance, long calendar spreads profit from increases in implied volatility.

Generally, calendar spreads aren’t a very directional strategy. But depending on the strike selection, calendar spreads can be set up more and less directional.

What are diagonal spreads?

Diagonal spreads are a combination of vertical and horizontal spreads. A diagonal spread is a strategy that consists of the same number of long as short options that have different strike prices and different expiration dates.

The options used in vertical spreads only differ in regards to strike price, the options used in horizontal spreads only differ in regards to the expiration date and the options used in diagonal spreads differ in regards to both strike price and the expiration date.

There are many different ways to set up diagonal spreads. But here are a few concrete examples of possible diagonal spreads.

Diagonal spread example 1:

  • 1 short XYZ call with a strike price of 185 that expires in 27 days (front-month).
  • 1 long XYZ call with a strike price of 190 that expires in 55 days (back-month).

Diagonal spread example 2:

  • 1 long ABC put with a strike price of 78 that expires in 20 days (front-month).
  • 1 short ABC put with a strike price of 72 that expires in 48 days (back-month).

Just like I said before, diagonal spreads are a combination of vertical and horizontal spreads. This means that they try to profit from changes in both the underlying asset’s price and implied volatility/time. Diagonal spreads can be slightly to very directional strategies.

Recap – Options Spreads Explained

It is very important to understand what an options spread is and what different kinds of spreads exist. That’s why I want to recap some of the most important points of this article.

I created the following table to visually explain the different options spreads. Furthermore, this table actually reveals why the different spreads are called the way that they are (horizontal, vertical, diagonal).

Now you should know what different spreads exist. But you might ask yourself the question, which of these spreads is best.

There is no one right answer to this question. Not one spread is better than another. It really depends on the current market situation and on personal preferences. For instance, if you are bullish on a stock and want to take advantage of an up-move, a bull call vertical spread might be a good strategy. However, if you want to profit from a rise in implied volatility and don’t have a certain directional assumption, a horizontal/calendar spread would probably be a better choice…

I hope you understand what I am trying to say.

But generally speaking, vertical spreads are the simplest of the three. Horizontal and especially diagonal spreads are much more complex due to the different expiration dates of the different options. Therefore, I wouldn’t necessarily recommend trading (horizontal or) diagonal spreads if you aren’t completely familiar with them.

In the introduction, I mentioned that if you fully understand options spreads, you will understand all options strategies. But why do I think this?

The reason why I am saying this is that options spreads are the building blocks of almost all other options strategies. If you combine multiple options spreads, you can create almost any strategy. So instead of trying to understand how these dozens of different strategies work, it is much more efficient to learn how the building blocks of these strategies work.

Let me give you a few examples:

You probably realized that vertical spreads are relatively simple (compared to other options strategies). They are a two-leg strategy that consists of a long call and short call or a long put and short put.

But what happens if we combine multiple vertical spreads?

A new strategy is born! There are four different vertical spreads that can be combined to create a new strategy. I will now give you some concrete examples of what happens when you combine multiple vertical spreads.

Iron Condor

You may or may not know the option strategy iron condors. It is a very good and popular four-leg options strategy. Due to its four legs, it is usually labeled as an ‘advanced’ options strategy. But in reality, it isn’t anything else than a combination of two simple credit spreads.

I created the following image to explain this concept visually.

Hopefully, you can see how a combination of a bear call spread and a bull put spread create an iron condor.

Butterflies

Now let me give you another concrete example. Butterflies are another options strategy often referred to as complex and thus, only suitable for ‘advanced’ traders. But just like with iron condors, butterflies aren’t very complicated either. They are simply a combination of a bear call spread and a bull call spread.

Hopefully, these two examples make it clear how options spreads are the building blocks of most options strategies. These were just two of many examples where this is the case.

So in conclusion, options spreads can be thought of as Lego bricks. Just like Legos, options spreads can be combined in many different ways to create whatever your heart desires.

If you want to learn more about options strategies and when to use which strategies, you might want to check out my free strategy selection handbook.

My goal with this article was to introduce you to options spreads and thereby build a stable foundation for options trading strategies. It would be awesome of you to let me know if I achieved this goal in the comment section below!

Furthermore, if you have any questions, feedback or other comments, please tell me in the comment section.

10 Replies to “Options Spreads Explained – A Complete Guide”

Your explanation of the Option Spreads as building blocks to other strategies makes sense, but I am confused by the Iron Condor and Butterfly.

Does the Iron Condor and Butterfly make you money if the underlying asset price does not go over a certain amount or go over and then come back down before expiration?

That’s kind of what it looks like from looking at the graphs you included.

Thanks for your question. Iron condors and butterflies profit if the underlying asset’s price stays in a certain range. The size of this range depends on the strikes selected and the premium received/paid. I hope this helps with clarifying the confusion.

Otherwise, you could check out my article on Iron Condors and Butterflies.

Reading through this very comprehensive article on Option Spreads in Trading was so interesting. For someone new to this world of Trading it would need to be gone through a few times to fully understand all the terminology and nuances of trading. It is really complex for an ordinary person not versed in doing anything like this previously.

To my mind, if you are ready to Trade, you would need to be aware of the risks involved and not be afraid of losses. Only Trade with the amount you can afford, would be my way of thinking. Perhaps am too conservative.

It was very interesting to learn something new. Will take a look at it again at a later stage.

Thanks for the comment Jill. It is completely normal for people new to the world of trading to have trouble understanding everything. That’s actually also why I created a free trading terminology handbook in which you can look up all the seemingly complicated trading terms. So judging from your comment, you could definitely use my free trading glossary.

And no you are not too conservative! You should never risk more than you can afford to lose.

Hi Louis, I have completed your education classes and they are good, and I have learnt a lot. Best of all, I have learnt more from your free education than all the other programs I have paid for. Be leave me I have spent a lot of money on paid sites and it is not worth it. Selling short term options is my goal. However, I am have trouble comprehending receiving a credit when I sell an option. When I sell an option for a credit, I only receive the credit if it expires worthless Right. Thanks for your help

Hi Tom,
Thanks for the question. I hope I can clarify your confusion. When you sell an option to open a position, you receive a credit. So now you have a negative position open. To close this position, you could either buy back the sold option or wait until expiration. If you buy it back, you will give up some of the received credit. The amount of credit that you give back depends on the option’s price. If it has gone up, you might even have to pay more to close the position than you received when opening it.
If at expiration, the underlying’s price is at the right point, the option might expire worthless and only then, you could keep the entire credit that you collected when putting on the position.

Let me give you a concrete example:
You sell a call option with a strike price of $105 on XYZ which is trading at $100. You receive a credit of $1,50 (so $150). But now you have an open position which has to be closed for you to lock in the profit. As long as the position is open, the profits (or losses) are purely paper profits (or losses). They are only realized if you close the position which you can do by buying back the call option or by waiting until the expiration date.
Let’s say, you buy back the call option for $0,7 two weeks later. This would mean that you have a realized profit of $1,5 – $0,7 = $0,8 (or $80). So you can keep $80 of the collected credit.
If you instead wait until expiration and XYZ’s price is still below $105, you can keep the entire $150 of credit.

I really hope this helps. If you have any other follow-up questions, let me know.

Hi Louis,
In your reply to Tom looks like you did not mention that at expirations time if the stock price is above the strike price in a short call or below the strike price in short put, he would be forced to buy the stock at the strike price.

Thanks for the comment. Usually, when a trade such as a short call or short put is ITM shortly before expiration, I recommend closing the position for a loss. If you do this, you won’t have to buy or sell any shares at the strike price. I never recommend holding a losing short option position into expiration (unless you want to buy or sell stock at the strike price).
But you are right that if you would hold such a position into expiration, you would have to buy/sell stock at the strike price.

since a call spread would probably be assigned if the stock price goes above the strike price, it seems to me that it would be better to use a put spread when one expects the stock to go up and a call spread when one expects it to go down. Opposite of single options.

Hi and thanks for your comment,
I wouldn’t use assignment risk as a main factor when choosing which strategy to go for. Instead, I recommend looking at different market variables such as implied volatility, time till expiration, underlying asset, and price. Depending on the situation and your market assumption, a bull put spread can be better than a bull call spread and vice versa. The same goes for bear spreads. It depends on the situation.

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