Understanding Basic Option Spreads

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Option Spreads I: Basic Bull and Bear Spreads
This report is part of an ongoing series on option spreads. Spreads are combinations of different option positions on the same stock.

Spreads are really not that complicated once you understand a few basic principals. The spreads that we will cover in this series will all have limited risk. Some of them can offer investors very efficient use of their capital.

Bull vs. Bear
You create basic bull and bear spreads by simultaneously buying and writing calls or puts (not both) on the same stock with the same expiration but with different strike prices.

The risk/reward characteristics of the spread will depend on the price and the strike prices of the options you buy and the options you write. You have all heard "buy low, sell high if you are bullish." This adage can help you remember how to structure your spreads.

• Bullish: Buy Low and Sell High. In a bull spread, the investor simultaneously buys the lower strike call (or put), and sells the higher strike call (or put).

• Bearish: Buy High and Sell Low. In a bear spread, the investor simultaneously buys the higher strike call (or put) and sells the lower strike call (or put).

Debit vs. Credit
The required margin on a credit spread is equal to the difference between the two strike prices times the number of underlying shares. This amount represents the most the investor can lose on these positions (e.g., $1,000 for an option on 100 shares with the strike prices $10.00 apart).

However, your actual capital requirement is reduced by the fact that you are allowed to apply the net credit of premium to this margin. In contrast, margin requirements on "naked" option writes can be hefty.

Here, you are required to post the entire premium taken in plus a percentage of the underlying value (20%, less the amount out-of-the-money, or 10%, whichever is greater).


A Bull Put Spread from a "Naked" Put Write Recommendation

• Debit Spreads: Bull spreads constructed with calls (bull call spreads) and bear spreads constructed with puts (bear put spreads) require that you pay a net payment of premium, since you are buying the higher premium option and selling the lower premium one. We call these spreads "debit spreads," because your broker debits your account for the net premium amount. With a debit spread, the most you can lose is this net premium you paid, while your potential gains are limited by the option you wrote. The Exchanges do not require a margin on debit spreads.
  

• Credit Spreads: Bear spreads constructed with calls (bear call spreads) and bull spreads constructed with puts (bull put spreads) always involve selling the higher premium option and buying the lower premium one. We call these spreads "credit spreads" because your broker credits your account with the net premium.With these spreads, the Exchanges require that you post a margin equal to the difference between the two strike prices. This margin covers your maximum possible loss on the spread. With a credit spread, you are allowed to apply your net credit of premium toward this margin requirement.
  

Continued In "Part Two: Time Value Is The Key"

Posted By: Value Line
 
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