'Option Spreads' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Option spreads are option combinations which have traders combining two different options contracts with varied strikes but identical expiration dates. They do this in a strategy to limit their overall risk. The idea behind these option spreads is relatively simple, but the possible effects of some spread constructs can become slightly more complicated.
Reducing the concept of option spreads to their most intuitive elements involves the discussion of the two legs, or option contracts, which comprise the spread itself. Putting on two legs refers to traders combining as an example a call option purchase with one which they sell at the same time. In other words, the traders who enter this strategy will take on both sides of the market when they make options spreads. It will either be in buying the one and selling the other, or selling the one and buying the other option contract.
The idea behind buying and simultaneously selling two options with the same expiration but different strikes is that this action reduces the risk. When traders sell a call and also buy a call, they are less exposed to a fall in the market or the option premium time decay thanks to the option which they sold, for which they received a premium. The net cost of the spread is therefore less than that of simply buying a call.
Another way of looking at this maneuver is that the cost of the one call is subsidized by the sale price of the one which the traders sell. The one sold is further out of the money than the one bought, which reduces the cost of the overall spread options. This effectively limits aggregate risk, exposure to the relentless time decay factor, and the penalty for the price movement potential to the downside.
Consider a real world example. If HSBC bank stock is trading at $53 per share and traders believe that the stock price will rise in the short term, they might decide to put on a bull call spread. They might construct this spread by buying a $55 strike price call at the same time as they sell a $60 strike price call. The expiration date in this example is irrelevant so long as the two call contracts have the same expiration date. In this example, the traders pay $500 for the $55 strike call and receive $250 for the $60 strike price call. The net cost of the spread position is $250 then.
In this example, the maximum risk is limited to the $250 net cost of the spread. Instead of having a $500 risk from only buying the single $55 strike price call, risk is reduced in this case by half for also selling the $60 strike price call. The trade off for this lowered risk is a reduced maximum potential profit. The reason is that as the stock price reaches $60 per share, the spread owners realize their maximum profit point. This is $500 gross realized for a $250 maximum net profit (maximum $500 gross proceeds minus the $250 spread cost). Even if the stock price were to rise to $65 per share, it would not change the profit possibility, since the sold call with a strike at $60 means that the spread owners can not capture any additional gains in the price of the stock beyond the strike price which they already sold.
If the price of the stock moves against the spread owners, they can not lose any more money than the maximum $250 net cost of the spread, regardless of how low the underlying stock price moves against them. This makes these bull call and bull put spreads very popular with options traders, since they are effective at reducing risk while still allowing for large profit potentials.
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