A call spread implies buying a call option with a strike price of K1 and simultaneously selling a call option on the same underlying asset and with a similar expiry date, but with a higher strike price of K2. Usually, traders buy call spreads in anticipation of a limited price increase in the underlying asset. The difference between the strike prices of options bought and sold is the strategy's maximum profit less the value of the call spread.
Chart. Call Spread
Example. Suppose the share of JP Morgan Chase bank is traded at $50. The investor buys for $0.62 a one-month (expiry date in one month) call option with strike price $51 and sells for $0.03 a one-month call with strike price $55. The value of the call spread in this case is $0.62 - $0.03 = $0.59.
The maximum profit from the strategy will be equal to:
$55 – $51 – $0,59 = $3,41
if the asset price exceeds $55, and minus $0.59, if the asset price is below $51 at the time of expiration. If the price of the asset at expiration stops between $51 and $55, the investor will earn:
Spot price - $51 - $0.59 = Spot price - $51.59
Generally, a call spread strategy is implemented using out of the money (OTM) options. Read Options trading: popular strategies, charts, examples.
The put spread option strategy implies:
1) buying a put option with a strike price of K2 and
2) simultaneously selling a put option on the same underlying asset and with the same expiry date but with a lower strike price of K1.
Usually, traders buy put spreads
1) when a limited fall in the price of the underlying asset is expected, or
2) when they expect a change in the volatility skew.
The difference between the strike prices of options purchased and sold is the strategy's maximum profit less the value of the put spread.
Chart. Put Spread
Let's assume that the share of Caterpillar is trading at $90. The investor buys for $1 one-month (expiry date in one month) put option with a strike price of $88 and sells for $0.31 one-month put with a strike price of $85. The value of the put spread in this case is $1 - $0.31 = $0.69.
Maximum profit from a strategy can be equal to
$88 – $85 – $0,69 = $2,31
if the price of the asset falls below $85, and minus $0.69 if the price of the asset is higher than $88 at the time of expiration. If the price of an asset stops between $85 and $88 at the time of operation, the investor will earn:
$88 - Spot price - $0.69 = $87.31 - Spot price