Spreads: Overview and Classification
Before diving into specific spread strategies, it helps to understand the framework: what a spread is, 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 |
- The Series 7 primarily tests vertical (price) spreads: same expiration month, different strike prices
- You may see time spreads or diagonal spreads in a question, but the frequent testing is on verticals
Exam Tip: Gotchas
- "Vertical" and "price" spread mean the same thing. The exam may use either term. 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.