I’m not a novice trader, and I’ve read a few books on options. But to be honest it’s hard to keep track of all the different kinds of spreads out there, especially when you start doing trades with three or more legs. I mean I know the terminology: verticals, diagonals, butterflies, iron condors, double diagonals, calendars, etc. But how to keep them all straight in my head; how do I know what spreads to use, and when? Thanks.
Great question: especially when you’re first getting started in options, it can be daunting to have to learn what all those spreads are. It seems like homework – and is definitely more complicated than flipping stocks, right? Compare: you have a stock, and you can buy it or sell it. Or you have an underlying stock or index or commodity, and you can trade any number of spreads on that underlying, and you can sell the spread to open, or buy the spread to open, and you have to choose an expiration cycle, and…
But it needn’t be so complicated, once you realize that trading option spreads is all about managing risk. And when it comes to risk-defined options spreads, there are actually only two types of spreads, from which all other traditional spreads can be constructed. They are:
- Calendar spreads – in which you are long (short) one option that expires in a nearer month, and short (long) another option that expires in a farther month.
- Vertical spreads – in which you are long (short) one option that is closer to the underlying price, and short (long) another option that is farther from the underlying price, where both options expire in the same month.
Can we really explain all those other complex spreads in terms of these two simple constituents? Let’s find out:
- Diagonal spread – is just a vertical spread plus a calendar spread, where one of the vertical options overlaps with one of the calendar options. Example: put together a long SPY May 134/135 call vertical, plus a short SPY May/June 135 call calendar, and you get a short SPY May/June 134/135 call diagonal.
- Iron condor – is just two short verticals (a short vertical call spread and a short vertical put spread) stuck together.
- Butterfly – a butterfly is just a long vertical plus a higher or lower short vertical.
- Double diagonal – is just what it sounds like
Brain teaser: what about straddles and strangles?
[tags] options, spreads, calendar, vertical, diagonal, iron condor, straddle, strangle, butterfly [/tags]