Spreads are trades of offsetting options. Options give you the right to buy (via call options) or sell (via put options) a set amount of underlying assets, such as shares of a stock or exchange-traded fund, at a specified price -- the strike price -- on or before the expiration date. You use spreads to reduce risk, but you sacrifice some potential return. The events at expiration depend on the “moneyness” of the options in the spread.
TL;DR (Too Long; Didn't Read)
Whether or not a put or call is "in" or "out" of the money will directly affect what happens at the expiration of a vertical spread.
What Is Moneyness?
A put or call is “at-the-money” if its strike price is about the same as the price of the underlying asset. “Out-of-the-money” puts and calls have strike prices below or above, respectively, the asset price. “In-the-money” puts and calls are the reverse. Only in-the-money options have intrinsic value -- the difference between the strike price and asset price. In addition, options have time value, based on the hope that the option price will increase before expiration. Time value dwindles to zero by the expiration date.
Evaluating Option Expiration
An option's price is the "premium" -- buyers pay it and sellers collect it. If the option expires without intrinsic value, the premium is the buyer’s loss and the seller’s gain. An option that expires in-the-money is automatically exercised by the Options Clearing Corporation, leading to standard actions. A call buyer gives up the cash equal to the asset’s value at the strike price and gains the underlying asset. The call seller experiences the reverse actions. A put buyer gives up the underlying asset and gains the strike value of the asset.
Once again, the seller’s experience is the reverse. However, the traders may issue standing orders to offset their options at expiration -- the buyer sells an identical option "on the close" of the last day of trading, and the seller buys an identical one. This results in cash gains or losses without the transfer of the underlying assets. The amounts of the gains and losses are identical either way if you assume that any underlying assets are immediately sold at the transfer.
Understanding Vertical Spreads
In a vertical spread, you buy and sell matching options that differ only by strike price. For example, in a vertical call spread, two calls share the same expiration date and underlying asset. Because they have different strike prices, they also have different premiums.
Three expiration outcomes are possible: both options expire in-the-money, both kick the bucket out-of-the-money, or one expires in-the-money while the other dies out-of-the-money. The implications of each outcome are different. Bull spread owners expect higher prices; bear spreaders are pessimistic about prices.
Bull Spread Expiration
In a bull spread, the spread owner buys a near-strike option and sells a far-strike option. A near-strike option is at-the-money or not far from it. The far-strike option is out-of-the-money. The spread requires an outlay of cash by the owner because the near-strike option is the more expensive one -- the price difference between the two options is the spread-owner's debit and the spread sellers’ credit. Assume that both traders specify offset rather than delivery at expiration.
If both options expire out-of-the-money, the buyer loses and the seller gains the debit amount. If both options expire in-the-money, the spread buyer profits from the difference between the two strike prices minus the debit, which is the same amount that the spread seller loses. If only the near-strike option expires in the money, the buyer’s and seller’s profit or loss is the difference between the final price of the near-strike option and the spread debit/credit.
Vertical Bear Spread Expiration
The vertical bear spread is identical to the bull spread, except for the role reversal of owner and seller. The bear spread owner sells the near-strike option and buys the far-strike one. You might visualize the bear spread owner as the bull spread seller. You can choose from many variations on the plain vanilla vertical spread. For example, you might decide to use only out-of-the-money options in your spread.
This reduces the owner's cost but also the chances of making a profit. Before entering any spread, you might want to work out the maximum profit and loss so that you know the risks before committing your cash.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.