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# Basic option strategies

In this post, we kick off a discussion of option strategies by first discussing option spreads. While this series will cover several different classes of option strategies, it is by no means comprehensive as the number of different option strategies is very large (limitless even). We will focus on some of the most common strategies and discuss how they provide comprehensive targeting of your risk limits and desired payoff.

**Option Spreads**

By combining various long and short positions in calls and puts, we can obtain various option trading strategies that give rise to tightly calibrated payoff profiles. To demonstrate an example of this, weāll start first with spreads that involve the same underlier and expiration, but at different strike prices (i.e. weāll limit ourselves to vertical spreads for this article). Here are some of the most basic positions to get started.

**Bull call spreads**

A bull call spread is created when an investor buys a certain number of calls at a lower strike price, sayĀ *Kā*(50 in the example above), and sells an equal number of calls at a higher strike price, sayĀ *K*ā (150 in the example above). The premium for the call with strikeĀ *Kā*,Ā *cā*will be higher than the premium for the call with strikeĀ *Kā*,Ā *cā*, under normal market conditions. Therefore,Ā *cā*Ā >Ā *cā*, and the cost of the spread will beĀ *cā*-*cā*.

If the option expires with the price of the underlier belowĀ *Kā*, both calls are worthless. If the option expires with the price of the underlier betweenĀ *Kā*andĀ *K*ā, then the investor exercises the option with the lower strike price.

If the option expires with the price of the underlier aboveĀ *K*ā, then the investor exercises the option at the lower strike priceĀ *Kā*. But since the investor has sold the calls with a strike ofĀ *K*ā, they are obligated, at expiration, to sell an equal number of the underlier atĀ *K*ā. In this way the profit is limited to the differenceĀ *K*ā -*Kā.*

After doing this analysis, we can see why an investor might use a bull call spread as opposed to a plain call option. Though the upside of the position is limited toĀ *K*ā-*Kā,Ā *the premium paid for the call options atĀ *KāĀ *is offset by their sale of the call options atĀ *K*ā, so the net premium paid is reduced. As discussed earlier, compared to buying the call with strikeĀ *KāĀ *at a price ofĀ *cā*, this strategy will cost*Ā cā- c*ā whereĀ *c*ā is the price received from selling the call with strikeĀ *K*ā. The investor can use the bull spread to reduce their maximum loss, i.e. the price paid for the spread compared to the naked call, by sacrificing some potential upside. This is called a bull spread because the investor is expressing a ābullishā view on the underlying: that is, its price will increase.

**Bear Put Spreads**

The bear put spread is very similar to the bull call spread, but, as the name implies, it allows the investor to instead gain positive exposure to a range ofĀ *downside*Ā movements of the underlying

In particular, a bear put spread is created when an investor sells a certain number of puts at a lower strike price, sayĀ *Kā*(50 in the example above), and buys an equal number of puts at a higher strike price, sayĀ *K*ā (150 in the example above). The premium for the put with strikeĀ *K*ā,Ā *p*ā will be higher than the premium for the put with strikeĀ *Kā*,Ā *pā*, under normal market conditions. Therefore,Ā *pā*Ā <Ā *p*ā, and the cost of the spread will beĀ *p*ā-*pā*.

If the option expires with the price of the underlier aboveĀ *K*ā, both puts are worthless. If the option expires with the price of the underlier betweenĀ *Kā*andĀ *K*ā, then the investor exercises the option with the higher strike price.

If the option expires with the price of the underlier belowĀ *Kā*, then the investor exercises the option at the higher strike priceĀ *K*ā. But since the investor has sold the puts with a strike ofĀ *Kā*, they are obligated, at expiration, to buy an equal number of the underlier atĀ *Kā*. In this way the profit is limited to the differenceĀ *K*ā -*Kā.*

After doing this analysis, we can see why an investor might use a bear put spread as opposed to a plain put option. Though the upside of the position is limited toĀ *K*ā-*Kā,Ā *the premium paid for the put options atĀ *K*ā is offset by their sale of puts for the call options atĀ *Kā*, so the net premium paid to acquire the position is reduced. As mentioned earlier, this*Ā *strategy will costĀ *p*ā-*pā*Ā whereĀ *pā*Ā is the price received for selling the put with strikeĀ *Kā and p*ā is the price paid for the put with strikeĀ *K*ā. Again the investor has reduced their maximum loss, i.e. the price paid for the spread compared to the naked put, by sacrificing some potential upside.

**Further Reading**

Here, weāve shown two of the more simple options strategies, call spreads and put spreads. These strategies limit your potential upside, while allowing you to pay less upfront in premium. More advanced strategies, such as straddles and calendar ratios, are not as straightforward as these and will be covered in future articles. Keep an eye out for them!