As we know, there are just two types of options; puts and calls – and if you really break it down, there are just three things you can do can do with these contracts; spreads, straddles and combinations. Every advanced strategy is merely a variation of one of these basic constructs.

Spreads, Three Types

When an investor uses a spread strategy he is typically trying to do two things, first, take advantage of the difference in option premium values between strike prices, expiration dates or both and second, reduce the cost of purchasing the first option contract by gaining the proceeds for the sale of a second option contract. Thus, to establish a spread position the investor simultaneously buys one option and sells another of the same class with different terms.

Different terms? Just as there are three basic constructs for all advanced option strategies, there are three basic categories for spreads; vertical, horizontal and diagonal.

Vertical spreads are those in which the strike prices are different but the expiration date is the same, in effect, the investor is spreading the strike price. For example Jane is moderately bullish for Dell Computer and she decides to buy the Dell Computer January 45 call and simultaneously sell the Dell Computer January 55 call. By doing so she limits the amount of profit she can earn because s he has effectively capped Dell Computer at $55 but s he also reduces the cost of the January 45 calls by the amount of the premium received for the January 55 calls.

Horizontal spreads are those in which the strike prices are the same but the expiration dates are different, in effect, the investor is spreading time. These spreads, often called time or calendar spreads are effective when the investor feels the price of the underlying security common stock will remain relatively unchanged over the life of the written contract. For example Bill likes the prospects for Dell Computer longer-term but feels the stock will remain in a narrow range for the next month. He buys the Dell Computer February 45 calls and he simultaneously sells the Dell Computer December 45 calls. By selling the December 45 calls he reduces the cost of purchasing the February 45 calls by the amount of premium received by the sale of the December 45 calls.

Diagonal spreads are any combination of the vertical and horizontal spread. Investors may spread price, time or both. For example, Mike is also bullish for Dell Computer. He believes the stock is likely to move modestly higher in the short-term but the real gains will come over the next two months. He decides to buy the Dell Computer February 45 calls and simultaneously sell the Dell Computer December 50 calls. By doing so he effectively caps his profit potential in the month of December but he also reduces his cost for February 45 calls by the amount of premium received from the sale of the December 50 calls.

In each of these examples it is important to note that both the long and short options are of the same class (calls). Spreads always involve the same class of options. In fact, this option strategy takes its name from the difference between the two premiums involved in the transaction.

In review, a spread is an option strategy where the investor buys and sells an option of the same class. Price or Vertical Spreads are those where the options in a spread have different strike prices. Time, Calendar or Horizontal Spreads are those where the options in a spread have different expiration dates. Finally, Diagonal Spreads are those where the options in the spread have different expiration dates and different strike prices.

Now that we understand the ground rules for spreads let's take a look at some of the specific strategies.