How to Calculate Options Prices and Their Greeks: Exploring the Black Scholes Model from Delta to Vega

Chapter 12Spreads

Plainly buying a call or a put could become very costly when the market is slow/not going the right way. Losses can arise quite quickly and time decay can be painful. In order to mitigate these losses or to create the most optimal P&L sdistribution according to the assessment of the Future towards maturity, a trader can enter into a spread strategy. It consists of one long call or put and another short: the short option will partly offset the investment of the long option.

When the long and short strikes have the same maturity one usually speaks of a “call spread” or “put spread”, “horizontal call/put spread” or “bull/bear spread”. With different maturities, the strikes being the same, one speaks of “time call/put spread” or “vertical spread”. When maturities as well as strikes differ, these strategies are called “diagonal spreads”.

When the long and short strikes are set up with differing volumes for each strike, quite often the further out of the money strike in a higher volume than the more at the money, the combination is called a “ratio spread”.

CALL SPREAD (HORIZONTAL)

When entering a (long) call spread, one buys one strike and sells a higher strike. For the put spread it's the other way around – buy a higher strike and sell a lower strike. The initial investment is obviously lower than just buying the call option at the lower strike. When the Future is trading at 50, a trader could buy the 50–55 call spread, buying the 50 call, selling the 55 call. ...