Quick Answer
A spread is the simultaneous purchase and sale of two options of the same class (both calls or both puts) on the same underlying stock, which caps both max gain and max loss. Spreads are named by what differs: strike price (vertical), expiration (time/calendar), or both (diagonal). The exam focuses on verticals.
Before diving into specific spread strategies, it helps to build the framework: how spreads are named, and how to quickly identify whether a spread is bullish or bearish, debit or credit.
What Is a Spread?
- A spread involves the simultaneous purchase and sale of two options of the same class (both calls or both puts) on the same underlying security
- Spreads limit both risk and reward: the maximum gain and maximum loss are both capped
- This makes spreads lower-risk than outright long or short option positions
Three Naming Conventions
Spreads are identified by three naming systems. Each describes the same position from a different angle:
| Naming Convention | What Differs | What's the Same | Example |
|---|---|---|---|
| Price (vertical) spread | Strike prices | Expiration month | Buy XYZ Oct 50 call / Sell XYZ Oct 60 call |
| Time (horizontal/calendar) spread | Expiration months | Strike price | Buy XYZ Oct 50 call / Sell XYZ Jan 50 call |
| Diagonal spread | Both strike prices AND expirations | Underlying security | Buy XYZ Oct 50 call / Sell XYZ Jan 60 call |
- Vertical (price) spreads are the most common: same expiration month, different strike prices
- You may see time spreads or diagonal spreads, but the focus is on verticals
Exam Tip: Gotchas
- "Vertical" and "price" spread mean the same thing. Either term may be used. If both options share an expiration but have different strikes, it is a vertical (price) spread.
Debit vs. Credit
- A debit spread occurs when the investor pays more for the long option than received for the short option (net cash outflow)
- A credit spread occurs when the investor receives more for the short option than paid for the long option (net cash inflow)
- The option with the higher premium determines the direction of cash flow
Think of it this way: "Debit" means money left your account (you paid net). "Credit" means money came in (you received net). Just like a bank statement: debits go out, credits come in.
Bullish vs. Bearish Identification
- Bullish spreads profit when the underlying stock price rises
- Bearish spreads profit when the underlying stock price falls
Quick identification rules:
| Spread Type | Bullish If... | Bearish If... |
|---|---|---|
| Call spread | Investor buys the lower strike (higher premium) | Investor sells the lower strike (higher premium) |
| Put spread | Investor sells the higher strike (higher premium) | Investor buys the higher strike (higher premium) |
The logic: buying the option that benefits from a price increase = bullish. Buying the option that benefits from a price decline = bearish.
Exam Tip: Gotchas
- To identify bullish vs. bearish, look at which option was BOUGHT. For calls, the lower strike has the higher premium; for puts, the higher strike has the higher premium.
- The higher-premium side determines debit vs. credit. If you NET paid money, it is a debit; if you NET received money, it is a credit.
What Should You Check on Exam Day?
- Confirm whether the two options share the same class (calls with calls, puts with puts) before calling a position a spread
- Identify the naming convention first: same expiration/different strikes = vertical, same strike/different expiration = time, both different = diagonal
- Determine debit vs. credit by checking which leg carries the higher premium, then decide bullish vs. bearish by checking which leg was bought