When most people think of investing, they think of buying stocks. That is the classic epitome of what investing consists of: buying a shares of a company in the hope that those shares will rise in value. Obviously, the investing universe is infinitely more complicated than that, but to the wider world, that will likely always remain the vanilla, standard vision of investing.
No so with the option markets. In option trading, it is possible to combine various positions in order to take advantage of an expected move in an underlying asset, while still limiting risk and achieving increased flexibility. This can be done in a relatively basic way - combining the buying and selling of puts and calls in a way that forms a coherent strategic play. This makes options spreads powerful trading strategies. Using these relatively simple combinations of options can make for a far more nuanced trading approach.
However, buying a stock is not always the optimal way to profit from an upward move in a stock, a fact any options trader knows well. There are any number of ways to benefit from an upward move in a stock, with options providing significant risk benefits compared to the outright purchase of company shares. Beyond that, there are a number of option spread strategies that provide additional benefits when attempting to take advantage of a bullish outlook for a particular asset.
A Bull Call Spread, or Long Call Spread, is formed when an investor buys calls on an underlying stock at one strike price and sells the same number of calls at a higher strike price. The expiration dates for the calls is the same. The goal of the strategy is to make money from the predicted upward movement in the underlying stock price. However, the structure of the strategy limits the cash required upfront. Also, using the options strategy mitigates the risk the stock will decline compared to purchasing the stock outright.
The purchased calls allow the investor to take advantage of any increase in the stock's price - anything above the purchased call's strike price represents a potential profit. The sold calls help mitigate the cost of setting up the trade. The cash received from selling the calls defrays part of the cash outlay necessary to buy the calls that make up the other leg of the spread. However, selling the calls also limits the upside possible from the strategy. The tradeoff inherent in the Bull Call Spread is that while lowering the upfront costs, the profit potential is also limited.
A Bull Put Spread, or Short Put Spread, is created by buying puts for an underlying stock at a certain strike price, while simultaneously selling the same number of puts for the same stock at a higher strike price. The expiration dates for all the options is the same. In this case, setting the strategy earns cash at the outset from the selling of the puts (offset in part by the cash needed to purchase the puts in the other leg of the spread).
As with the Bull Call Spread, the potential profit is limited, as the maximum amount that can be earned is the net premium received at the outset. However, the risk is limited as well.
The bull put/call spreads described above have the same potential profit and loss, taking into account the net cost of carry. Both strategies have limited profit potential, as well as limited risk potential.
In the call spread, cash is received upfront, with potential losses to be paid out later. The put spread requires cash to be paid out when the trade is set, with profits possibly achieved in the future. The choice between the two would depend on the cash position of the investor and on his or her cash management strategy.
Take a look at the following example of a Bullish Call Spread and Bullish Put Spread taken from SPY [SPY Strategy Payout]. In each case, the ATM strike is 210. For the call spread example, the trader buys 1 option at the 210 strike and sells 1 option at the 215 strike. For the put spread, in this case, the traded buys 1 put option at 205 and sells 1 put option at 210. The payouts look relatively the same, but the difference will be in the initial cost and the total price for the options.