What are the Differences between Call Spreads and Put Spreads?
Options traders usually get started by purchasing individual calls and puts. While this approach can have great upside, it has risks and can get expensive. Call spreads and put spreads offer a valuable alternative that is generally more affordable. However, it’s important to know how they both work, along with the pros and cons, before getting started.
What Is a Call Spread?
A call spread is an options trading strategy that involves simultaneously buying one call and selling another call. Each of these calls is of the same underlying stock and often has the same expiration date. The only difference between most spreads is their strike prices.
How Does a Call Spread Work?
A call spread can be a more cost-efficient way to trade options that involves buying and selling a call of the same underlying stock. Because a trader buys a call and sells a call at the same time, the premium from the sold call can help offset some of the premium you paid for the long call. Some traders pay a smaller premium because of the short call, while other traders realize a premium for initiating the position.
Types of Call Spreads
You can buy and sell one call, but the strike prices you choose impact the strategy’s objective. Below are the types of call spreads options traders may use for their portfolios.
Vertical Call Spread
Vertical call spreads involve long and short calls of the same stock that have the same expiration date. The only difference is the strike prices, and that difference determines whether a vertical call spread is bearish or bullish.
For a bearish vertical call spread, the sold call option will have a lower strike price than the purchased call option. If a trader sells a call with a $40 strike price and buys a call with a $45 strike price, the trader will receive a premium.
During a bullish vertical call spread, the long option has a lower strike price than the shorted option. If a trader buys a call with a strike price of $30, the trader may sell a call with a $32 strike price. This spread results in the trader paying a premium to initiate the position.
Calendar (Horizontal) Call Spread
Calendar call spreads involve a long call and a short call of the same underlying stock with the same strike price but different expiration dates. Traders initiating bullish calendar call spreads may buy a call that expires in a few months and sell a call that expires within a few weeks. Both of these calls have the same strike price. Bullish traders position their strike prices out of the money, while neutral traders position their strike prices at the money.
Traders aim to profit from theta decay on the shorted calls with closer expiration dates. As an option gets closer to its expiration date, it becomes less valuable. The short call has a closer expiration date and will expire sooner than the long call. Even though both calls have the same strike prices, if the underlying stock remains steady or declines during the life of the shorter-term option, then the short call can expire worthless, and the long call is still open with the hopes it can bring in a profit. The different expiration dates create that possibility.
Diagonal Call Spread
A diagonal call spread involves a long call and a short call with different strike prices and expiration dates. This options trading strategy has more variation with risks and rewards. Some traders set their long calls to expire before short calls, which would leave them with a naked call — a position with unlimited risk potential. You can choose whether to pay or receive a premium based on how you set up the strike prices and expiration dates.
Possible Advantages of Call Spreads
Call spreads present several advantages for traders.
Call spreads can be more cost-efficient: Every spread involves buying and selling one call. The premium from the sold call lowers the total cost of the position. It is more expensive to buy a call without selling a corresponding call.
Reduce your risk: A lower cost to initiate a debit call spread position means you probably won’t lose as much money if the stock moves against you.
More ways to potentially profit: Some call spreads benefit from short-term sideways movement in the stock market. Call spreads give traders more ways to potentially generate gains rather than buying a call and having only one path to profitability. Call spreads can also serve as a good introduction to more complex trading strategies.
Risks of Call Spreads
Call spreads can help options traders potentially grow their portfolios, but this options trading strategy has some risks. No strategy is perfect, and these are some things to keep in mind before trading call spreads.
You limit your potential gains: Selling a call limits how much you can gain if the stock moves in your direction. If you buy a call without selling a corresponding call, you open the door to unlimited potential gains.
The options can still expire worthless: You can lose on any investment, including call spreads. While spreads are generally less risky than single-leg options, the lower risk may result in traders taking larger positions that increase their total risk. Avoiding these common options trading mistakes can increase your likelihood of making profitable trades.
Higher trading fees: Some brokers charge a fee for each option contract. If you initiate a call spread, you have to pay fees for two options instead of only one. You will have to pay the extra fees again if you close the position early instead of letting it expire.
What Is a Put Spread?
A put spread is like a call spread but with puts. An options trader can initiate a put spread by purchasing one put and selling one put.
How Does a Put Spread Work?
Put spreads give traders a more cost-efficient way to get into options. The premium from the sold put can help offset some of the total cost of the position, and some traders adjust their strike prices to receive a net premium. The strike prices and expiration dates you choose for your two puts impact the type of spread and the direction you want the stock to move.
Types of Put Spreads
Options traders can use several put spreads aiming to capitalize on stock price movements. They are similar to the call spreads mentioned earlier.
Vertical Put Spread
Traders initiating vertical put spreads will buy one put and sell another. These puts have the same expiration dates but different strike prices. A bullish vertical put spread involves buying a put with a lower strike price and selling a put with a higher strike price. The investor realizes a net premium and benefits if the stock’s price moves upward.
A bearish vertical put spread involves buying a put with a higher strike price and selling a put with a lower strike price. The investor pays a net premium to enter the position and benefits if the stock’s price moves downward.
Calendar (Horizontal) Put Spread
Calendar put spreads involve buying and selling a put with the same strike prices but different expirations. The sold put has a closer expiration date, while the purchased put expires later. It’s possible to make money on both puts if the sold put expires worthless and the stock’s price goes in the money for the long put soon after the short put expires.
A bullish put spread takes shape if a trader chooses an out-of-the-money strike price. A neutral put spread involves buying and selling a put with an at-the-money strike price.
Diagonal Put Spread
A diagonal put spread involves buying and selling puts that have different strike prices and expiration dates. Diagonal put spreads give traders more variety and several ways to position themselves for a potential profit. A trader can opt to receive a net premium and hope for sideways or bullish movement. Traders can also set up diagonal put spreads to benefit from downward movement with a near-the-money long put and a far out-of-the-money short put.
While diagonal put spreads offer more flexibility, investors can lose money if the stock moves against them. The way you set up a diagonal put spread impacts your risk. Traders who receive net premiums stand to lose the most money if a stock declines. Traders positioning their diagonal puts to benefit from downward price movements may lose money if the stock rallies.
Possible Advantages of Put Spreads
Put spreads provide several advantages for options traders.
Put spreads are more cost-effective than single-leg puts: You generally don’t pay as much to enter a put spread because you receive a premium from the sold put. Some options traders set up their put spreads to receive a net premium for initiating the trade.
You put less capital at risk: Put spreads typically require less capital and make it easier to get started if you don’t have much cash to allocate for options. Any option can expire worthless, but you can limit your losses with put spreads.
Potentially profit from different types of market conditions: Put spreads give you the ability to profit from bullish, bearish and sideways markets. Spreads give you more flexibility than single-leg options.
Risks of Put Spreads
Put spreads have their benefits, but no trading opportunity is perfect. These are some things to consider before getting started with put spreads.
The options can expire worthless: You can lose money from options expiring worthless, similar to single-leg options. While the premium from a sold put can help offset some of the costs, you can still lose money from a put spread. Traders should consider their risk tolerance before entering spreads.
Your potential gains are limited: Single-leg puts have a higher theoretical max gain potential, but put spreads cap your potential gains.
Trading fees: You will have to contend with options trading fees that can make your breakeven price more difficult to attain. Transaction costs can be higher with spreads than with single-leg options.
Summary About Option Spreads
Call and put spreads allow traders to potentially profit from price fluctuations in the market. You can set up a spread with the ability to benefit from either an upward, downward or sideways movement. Spreads also give traders flexibility with how they choose strike prices and expiration dates. If you find options difficult to get into because of the premiums, option spreads can help make it more affordable when compared to some single-leg strategies. Your potential gains are limited and transaction costs may be higher, but it may be easier to enter spreads and get involved with less capital.
Frequently Asked Questions
Which is better: bull put spread or bull call spread?
Bull put spreads and bull call spreads are similar options trading strategies that aim to benefit from upward stock price movement. Your gains are capped with either strategy, and one isn’t necessarily better than the other. Investors receive premiums for bull put spreads and pay premiums for bull call spreads.
Is a call spread bullish?
A call spread can be bullish or bearish. It depends on how you set up the strike prices and expiration dates.
What happens when both options in a bull call spread expire in the money?
You realize a profit, and the two options essentially cancel each other out. In theory, for a bull call spread, the long call lets you purchase 100 shares at the lower strike price, while the short call has you sell 100 shares at the higher strike price. You don’t end up buying or selling 100 shares but realize the profit from an in-the-money spread. The max profit then is the difference between the two strike prices, less the initial premium paid to establish the spread.
